Rajan relieved as Fed paves way for RBI to roll back liquidity measures

The US Federal Reserve (Fed) drove the benchmark US equity index, the S&P 500 index to record high close on the 18 September 2013.

US benchmark ten year treasury yields fell by 15 bps while the USD index fell 1.1%.

Asian equities, currencies and bonds will rally on the back of US market movements.

The Sensex and Nifty are likely to show strong rally from current levels of 19,960 and 5900 while the INR will strengthen from levels of Rs 63.38 to the USD.

The benchmark ten year bond yield will drop from levels of 8.43%. The reason for rallies in domestic equities, currency and bonds are that FII’s will pump in money into the market and that the RBI will roll back liquidity measures.

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[caption id=“attachment_1119481” align=“alignleft” width=“380”]  The Sensex and Nifty are likely to show strong rally from current levels of 19,960 and 5900 while the INR will strengthen from levels of Rs 63.38 to the USD. AFP[/caption]

The Fed kept the pace of its asset purchase program at $85 billion a month, surprising markets that were expecting a partial rollback in the central bank’s 18 September 2013 policy meet.

The Fed said that it required further confirmation of sustained economic recovery before tapering off its asset purchase program.

The central bank revised its forecast for US economic growth in 2013 to 2% to 2.3% down from 2.3% to 2.6%.

The Fed indicated that if economic conditions improve, bond purchases would be lowered by end of 2013. However the central bank reaffirmed that interest rates will stay at close to zero percent as long as unemployment rate stays above 6.5% and inflation trends below 2.5%.

Fed was worried about bond markets reaction to tapering off asset purchases with treasury yields jumping by 75bps from June 2013.

Rising mortgage rates that rose by 120bps from lows hurts the US housing market that is seeing recovery from the crash of 2007-08. Faltering housing market hurts economic growth in the US and the Fed did not want to hurt the growth prospects of a still fragile housing market. Hence the continuation of bond purchases.

RBI can heave a sign of relief now as it has borne the brunt of global market volatility that commenced in June 2013.

FII’s have pulled out over $7 billion from INR bonds in the May - September 2013 period, leading to the INR falling by over 25% to record lows of Rs 68.80. RBI had resorted to liquidity tightening measures of restricting banks borrowing in the LAF (Liquidity Adjustment Facility) and raising overnight money market rates by 300bps by hiking the MSF (Marginal Standing Facility) rate by 200bps from 8.25% to 10.25%.

The positive reaction by the markets to the Fed maintaining bond purchases will enable RBI to roll back its liquidity tightening measures. Banks have borrowed Rs 130,000 crores through the LAF and MSF windows as of 17 September, indicating the tight liquidity conditions prevailing in the market. RBI is likely to remove restrictions on LAF and bring back MSF to levels of 100bps over repo.

Dr Raghuram Rajan, the new RBI governor will have positive news for the market in his first policy statement on the 20th of September.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors.