After US Fed’s surprise interest rate cut, all eyes on RBI’s management skills

The US Federal Reserve surprised markets by opting for a significant rate cut of 50 basis points (0.5%) to the Fed Funds policy rate. While a rate cut was expected as inflation has eased in the US, the magnitude of this cut exceeded expectations. Most market analysts had anticipated a 25 basis point reduction, but the larger cut signals a much stronger intent. This move also suggests the Fed is likely to continue lowering rates in the near future.

The impact of this rate cut—and the prospect of further cuts—will reverberate across the global economy, given the dollar’s status as the world’s reserve currency. The US bond market, the largest and most liquid in the world, will see yields fall as returns on bonds and treasuries adjust to the lower interest rates.

Falling bond yields have several key implications. First, they push investors to seek higher returns in riskier markets. Second, lower interest rates typically cause the currency in question to weaken relative to others, which is crucial given the US dollar's dominance in global trade, currency markets, and its role in pricing major commodities.

Given that the US bond market, particularly the Treasury segment (US government debt), is considered the safest asset globally, traders will likely shift to riskier assets in search of higher returns—commonly referred to as a 'risk-on' environment. This situation is highly favourable for equities, especially in emerging markets like India, which are seen as riskier compared to euro-denominated markets.

India has already experienced a surge in foreign portfolio investment (FPI) in anticipation of a Fed rate cut. Over ₹30,900 crore of FPI flowed into rupee-denominated equities in September (up to 18 September), before the Fed’s move. The surprise 50-basis-point cut could further accelerate FPI inflows. In early trading today, the Nifty and Sensex hit record highs as traders rushed to capitalize on the favourable market conditions.

The expected weakening of the US dollar has additional implications. Currency traders are likely to speculate on the rupee (and other currencies like the euro) gaining strength against the dollar. The rupee has already appreciated from around ₹83.98 to a dollar in early September to ₹83.67 today, with further strengthening possible. (Note, the rupee strengthens when the US dollar loses value relative to it.) This could trigger additional speculative activity, as traders seek to profit from currency fluctuations.

Commodities priced in US dollar, such as industrial metals, gold, and coal, are also likely to see price increases on global exchanges as the dollar weakens. (When the US greenback loses value, it takes more dollars to buy the same amount of these commodities, pushing their prices higher in US dollar terms.) This will have a knock-on effect on India’s commodity markets, with traders anticipating price movements.

Other central banks, including the Reserve Bank of India (RBI), will need to respond to the Fed’s unexpected move. The RBI’s Monetary Policy Committee meets again during 7-9 October, and finding “an ideal range” for the rupee will likely be a priority. 

Also read | Food vs core inflation: No, RBI's rate policy doesn’t need a new playbook

The RBI faces the challenge of managing high FPI inflows and a strengthening rupee, which could hurt exports if the currency appreciates too much. Having held policy rates steady for some time, the RBI may now consider aligning with the Fed by cutting rates. With domestic inflation below 4% for the past two months (July and August), the RBI may have the room to do so, potentially adding further fuel to bullish market sentiment.