TWEET ANALYSIS

The RBI it seems has joined hands with the US FED and other key central banks to control
inflation and contract money supply in the economy by raising key interest rates (Repo rate
for the RBI and the federal funds target rate for the US Fed). Here the RBI has moved the
repo rate up by 50 basis points (0.5%) and the FED likely by the same. Looking at the
timeline of the rate hikes by both the central banks, the RBI has clearly followed in the
footsteps of the FED.

The RBI hiked the rate by 50 basis points on 30th September,2022 to reach a level of 5.90% in
its efforts to bring inflation under 6%.

1.1 Changes in Repo Rate by RBI

Source: bankbazzar.com

BACKGROUND

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Starting with the Federal Exchange of the US, it first acknowledged the presence of the
elephant in the room in March of 2022 when it raised its Fed funds target rate. Here is the
table showing the timeline of the further rate hikes and quantitative tightening.

1.2 Changes in Federal Funds Rate

Source: Forbes Advisor

Taking a look at the inflation in the United States and mainly focusing on expected inflation
because this is what drives the market in the long term, the chart below shows how the
economic giant was used to a decade of slow and steady inflation. This made it a bit difficult
for the FED to put a responsive front to rising prices.

September 2022 ended with an inflation of around 8%, expectations being between 6-7%.

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 1.3 Inflation Changes over time (United States Dollar)

Source: aswathdamodaran.blogspot.com

During 2021 it was easy and to a large extent true to blame supply chain bottlenecks
(Producers Price Index rises steeply through 2020 and majority of 2021 as the world is
engulfed by the Covid 19 pandemic, sign of cost push inflation) and fiscal and monetary
stimulus introduced by the various central banks at large to strengthen their respective
economies for the rising inflation.

(Credits: COVID-19 pandemic)

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Disruptions in the supply chain can also be noticed by observing the graph for Global Supply
Chain Pressure Index (GSCPI) computed by the Federal Reserve Bank of New York.

The GSCPI draws on key information from major supply chain indices such as the Baltic Dry
Index, Harpex index (These indices provide a benchmark for the price of moving the major raw
materials by sea and container shipping costs), BLS inbound and outbound air freight rates etc.

As pandemic and lockdowns chimed in, the shipping costs through sea and air both increased
significantly and hence the spike in GSCPI index through a majority of 2020-21.

1.4 Global Supply Chain Pressure Index (GSCPI)

Source: New York Federal Reserve

Down in 2022 came Russia’s invasion of Ukraine that drove the energy prices and that of key
natural resources through the roof. The Eurozone is still suffering heavily from the rising
energy prices and of course inflation which has currently touched 10% YOY.

1.5 Shift in energy prices in EU

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 Source: Council of European Union

1.6 Inflation in the European Union

Source: European Central Bank

THE INDIAN SCENE

India being an open economy did see inflation take over in the market as a result of the strong
global headwinds with inflation rates being around 7.4% for September and household
expectations being around touching as high as 10%.

1.7 Inflation in the Indian Economy

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 Source: tradingeconomics.com

1.8 Inflation expectations in India

Source: Reserve Bank of India

HOW DOES EXPECTED INFLATION DRIVES MARKET?

- When we consumers notice over a period of time that the price of a basket of goods
that we regularly purchase has risen, we set expectations for such price rise in the
future based on the past and current trends. This is known as expected inflation.

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- Every central governing body of a country issues bonds called sovereign bonds and
they trade in open market and yield a certain percentage return called the risk-free rate
based on the current bond price and the coupon payments.
- This rate reflects real growth in the economy and expected inflation. Inflation in the
economy decreases the real return on fixed income securities and they become less
attractive and as a result its demand falls which results in an increase in the yield or
risk-free rate.
- Interest rate hikes by central banks usually follow inflationary pressures to counter it.
These rate hikes now make fixed income securities more attractive and market
participants tend to flee from riskier segments of markets such as stock markets. This
leads to increased demand for sovereign bonds which is followed by a rise in its price
and a fall in its yield. New equity issues simmer down, corporate debt issuance
decreases, Private Equity and Venture Capital fund raising slows down and a
corporations finds it difficult to raise capital until overall market and macroeconomic
conditions turn favorable.
- The price of taking risk increases in markets i.e., risk premiums rise which increases
the overall expected rate of return from the riskier segments of the market.
- The yield curve for the Indian sovereign bonds seems to be flattening. Rates have
risen more at the short end of the spectrum reflecting high inflation expectations in a 3
months’ time.
- Having a minimum difference between the short term and the longer-term rates, the
long-term bonds (10 Y) for instance start to seem less attractive to consumers and this
represents a loss in the faith of long-term growth of the economy.

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 1.9 Indian Yield Curve

Source: www.worldgovernmentbonds.com
- Well, how does asset value shift on the basis of difference between actual and
expected inflation?
Case 1: If Actual inflation is greater than expected inflation:
The expectations need to be increased and this should reflect in an increased risk free
rate. This risk-free rate then builds into the discount rate for a DCF analysis and assets
are priced down.
Case 2: If Actual Inflation is less than expected inflation:
The expectations need to be decreased which will lead to fall in risk free rate, the
discount rate will lower down and when plugged into a DCF analysis should improve
the Net Present Value of the asset under analysis.
Case 3: If Actual Inflation reflects the expectations:
Assets are fairly priced and you are a GOD.

HOW DID SENSEX RESPOND TO INTEREST RATE CHANGES BY RBI?

As the first-rate hike was announced on 4th of May, 2022 the Sensex tanked by 500 points on
realization of a global recession. When the RBI announced its second-rate hike on 8 th of June,

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the markets rose a bit but, in the neighboring days, declined. The markets and Sensex
responded in favor of a third-rate hike by 1000 points in September as the markets were
drawing comfort from expectations that the RBI may be nearing the end of the rate hike cycle
in India.

Theoretically there is an inverse relation between interest rate hike and market index but
practically markets are inefficient and anything can happen!

Morale: Do not take bid on a shorter time frame, see the long end of the spectrum,
understand the implications and then place your bets on the market. Also, the effects of the
monetary policy measures taken by the central banks take time to be seen and felt on the
market.

2.0 Sensex chart

Source: in.investing.com