Why the markets will rise with rates

Rate hikes are likely to drive equity indices closer to record highs as foreign portfolio flows flood in on the back of a rising rupee.
The Reserve Bank (RBI) is more likely to raise rates by 50 basis points (bps) than 25 bps in its policy meet in the first week of May.

The reasons are:
a) Rising inflationary pressure in the economy as seen by March inflation numbers coming in much higher than RBI forecasts,

b) Expected hike in fuel prices leading to further rise in inflation expectations and

c) Expected appreciation of the rupee on the back of rate hikes, nullifying to some extent the rise in imported prices of oil and other commodities.

The Sensex and the Nifty will benefit from the rupee
appreciation with foreign institutional investors (FIIs) pumping more money into Indian equities. The FII flows will in fact take the Sensex closer to 21000 levels and the Nifty closer to 6200 levels in the immediate future.

Why should the rupee appreciate on the back of rate hikes?
The currency rally across the globe on the back of rate hikes by central banks is an indicator of the trend currently ruling markets. The US dollar has borne the brunt of the currency appreciation with the dollar index (DXY) losing 6.2% year to date. The DXY index at 74.10 as of April 21 is trading at its lowest level in the last two-and-a-half years.

Currencies which have seen rate hikes on the back of rising inflation expectations have gained considerably against the US dollar.

The Chinese yuan has gained 2% year to date against the USD and is trading at record highs. China has raised rates twice this year to quell rising inflation expectations.

Brazil raised rates last week and its currency, the real, rose to its highest levels in two-and-a-half years. The real has gained 5.7% against the USD year to date. The euro too has gained since the ECB rate hike this month.

The euro has gained 10% year to date and 2% month to date and is trading at a 16-month high against the USD. Russia, which hiked rates this year, has seen its currency gain 8.4% against the USD year to date.

The rupee has also benefitted from rate hikes with the INR trading near one-year highs against the USD. Hence, a higher-than-expected rate hike by the RBI will benefit the INR as the rate differentials will increase against the USD rates. The USD is on free fall on the back of the US Federal Reserve pledging to keep rates at all-time lows till US economic recovery gathers steam.
The recent move by S&P to place US AAA credit rating at ‘negative’ from ‘stable’ is a USD negative move as there will be concerns on foreigners willingness to hold on to US treasuries. Foreigners including China and Japan are the largest holders of US treasuries holding more than 30% of US debt.

The Sensex and the Nifty, at Wednesday’s close of 19448 and 5834, are still down around 5% year to date. The fourth-quarter corporate results show that the corporate sector is in an expansion mode and is optimistic on growth. Indication from tech biggies such as Infosys and TCS are that these companies will ramp up their staff strength by 25-30% this year. Other companies such as Reliance and ICICI Bank are optimistic on growth in the coming years. Corporate optimism coupled with rising FII flows will negate issues of scams and inflation that lead to falling equity indices. FIIs, who were net sellers of equities in the first two months of this calendar year, have turned net buyers with net equity purchases of over $3 billion in March and April to date. The FII buying is likely to continue on the back of a weakening USD, coupled with domestic corporate optimism.