Millions of investors across the globe will have their eyes glued to their screens tonight when the Federal Open Market Committee meeting gets underway. At stake is the answer to the trillion-dollar question of whether the Federal Reserve — in its wisdom —will decide to keep the interest rates higher for longer, or will it, as a few economists are hinting, make a hawkish pivot.

Chair Jerome Powell, could chalk out a future trajectory, without any rate cuts this year, or bring it down from the three rate cuts the other Fed officials were projecting.

Young retail Indian investors can mistakenly treat these macroeconomic developments lightly, believing instead that they won’t have an impact on the Indian markets. But that would be a costly blunder.

Market players love to cite a dictum. It goes: When the US sneezes, the world catches a cold. It means that macroeconomic and financial developments within the US have larger repercussions on the global economy. India is no exception to the rule considering the deep interlinkages between several large and small businesses between the two countries.

Despite the oversized role played by the Indian retail investor, FIIs, to date, occupy a very important place as movers and shakers in the Indian markets. Inflows from them have powered several stocks and segments to spectacular heights, which is one reason why many retail investors have made quick gains in the markets.

Any factor influencing their market behavior merits critical examination by the Indian investor. The upcoming FOMC meeting is one such event that will set the broader future narrative for FIIs. The tone, language and direction set by Chair Jerome Powell will be analyzed endlessly by foreign investors, and their investment decisions can power or pummel the Indian markets.

HOW ARE INDIAN STOCKS IMPACTED?

Before we understand how the Federal Reserve’s decision influences Indian markets, we need to decode the reasons why foreign investors invest in the Indian markets.

Traditionally speaking, the US markets have had a relaxed interest rate regime, where rates have been kept low to encourage consumption and business activity. A low-interest rate regime encourages US-based investors to borrow heavily from local banks and invest these funds in Indian securities and other instruments.

So, funds borrowed from US banks can be invested in India for a return of 10-12% or more. However, when the Federal Reserve hikes interest rates or steps away from cutting back the interest rates, the yield from US treasuries also spikes up. US treasury bonds are debt instruments issued by the US government via which it borrows money from the markets.

Think about it from the point of view of the foreign investor: You stand to gain 10-12% returns by investing in Indian equities, but your investment will remain clouded with risk. On the other hand, you could earn lower returns compared to Indian equities, but your capital will be safe as you are lending to the US government which is typically considered to be one of the safest investment assets. Where would you choose to invest?

Not surprisingly, many US investors liquidate their Indian holdings and make a beeline for the US treasuries every time US treasury yields jump.

Furthermore, an increase in the US interest rates makes the Indian Rupee weaker against the dollar, which further dilutes the returns of foreign investors from their Indian investments.

Additionally, with the increase in the US interest rates, the foreign investor will have to take on a higher interest burden on his loans. This adds to the investor’s worries as the demand for higher returns from Indian investments takes the investor towards riskier assets.

THE LAY OF THE LAND

One of the key mandates of the Federal Reserve is to ensure that inflation stays within the 2% target. This way, the cost of commodities and services remains affordable to people at large, and everyone can enjoy a certain standard of living.

However, bringing down inflation levels is easier said than done. To drag inflation down, the Federal Reserve has to reduce the business and lending activity within the economy. The only way to reduce the business activity is to raise the cost of funds, that is the interest rates at which people borrow money.

In the upcoming FOMC meeting, the Federal Reserve is largely expected to maintain its benchmark interest rate at 5.25-5.5%, underscoring the higher-for-longer stand. Core Personal Consumption Expenditure data, which strips out food and energy prices, for March stood at 2.8%, which was higher than economists’ expectations of 2.7%. PCE data also rose by 2.7% in March, once again higher than the economists’ expectation of 2.6%.

The Consumer Price Inflation data was also higher than anticipated. For March, it bounced up to 3.5%, the highest such increase since September last year.

Inflation is still running hot, and the Federal Reserve’s ratcheting of interest rates is not delivering the desired results yet. Meanwhile, the odds of achieving a soft landing are becoming steeper by the day.