The Indian stock market is significantly influenced by the decisions of the US Federal Reserve, especially its “interest rate policies”. Whenever the US Fed announces changes, even a slight increase or decrease in interest rates can cause notable fluctuations in Indian stocks. This high sensitivity is because these rate changes affect foreign investments. A rise in US rates can make it more attractive for investors to pull funds out of India, while a decrease may encourage them to invest more.

Recently, the US Fed made its first rate cut since 2020 of a significant 50 basis points. As a result, in FY24, foreign portfolio investors (FPIs) infused Rs. 2 lakh crore into the Indian stock market. This investment was primarily made in sectors like capital goods, consumer services, and automobiles. This inflow reflects a strong foreign interest in Indian equities.

In this article, we will explain in detail why and how US Fed interest rate changes affect the stock market. We will cover both scenarios of rate hikes and cuts.

• US Fed interest rate changes affect the stock market by impacting borrowing costs and international investment flows.
• Higher US interest rates make it expensive for foreign investors to borrow, causing them to shift funds from Indian markets to the US.
• Lower US rates reduce borrowing costs. This encourages foreign investors to invest in higher-growth markets like India.

Primarily, US Fed interest rate changes affect the stock market by influencing:

• The cost of borrowing
  and
• Global investment flows

Be aware that foreign investors often borrow money from US markets, where interest rates are low. They then invest in developing countries like India, where returns are higher. When the US Fed raises interest rates, borrowing becomes more expensive for these investors. This leads them to pull funds out of emerging markets like India.

Conversely, when the Fed lowers rates, borrowing costs decrease. This encourages more investments in India, as now investors can earn higher profits.

It is worth mentioning that several foreign investors choose India over the US because it offers higher growth potential. The US is a mature market with fewer growth prospects, whereas India is a developing economy and presents numerous opportunities for capital appreciation.

Additionally, India offers higher interest rates compared to the US. This makes it attractive for foreign investors to earn a greater return on their investments. Let’s understand this situation through an example:

• Say a foreign investor borrows money in the US at a 3% interest rate.
• They invest it in Indian markets, where returns can be as high as 12%.
• If the same investor borrowed funds in India, the interest rate could be 7-8%.
• This can significantly reduce their profit margin.

Therefore, by borrowing cheaply in the US and investing in India, investors can easily maximise their profits and benefit from the difference in interest rates. For those unaware, this practice is known as the "carry trade". Generally, it drives capital inflows to Indian markets.

US Fed interest rate changes affect the stock market through both a rate hike and a rate cut. Let’s see how a US Fed rate hike works:

• Less attractive Indian markets
  When US rates go up, foreign investors pull their money out of Indian markets. This is because the returns from the US (like government bonds) become more appealing than the Indian stock market. Hence, foreign investors move their money from India back to the US.
• Weaker Indian rupee
  Be aware that the US dollar strengthens due to higher interest rates and the rupee weakens. Now, this causes foreign investors to get less return when they convert their investments from rupees back to dollars. Such a situation discourages them and they often decide to shift investments to better markets.
• Short-term investors sell their investments
  While long-term investors might stay, those who are investing for the short term usually pull out. A weaker rupee and volatile markets make it harder for them to manage their investments. This reduces their returns and most prefer to square off their positions.

A US Fed rate cut positively affects both the US and Indian markets. For example, in November 2019, the US Fed cut its interest rates for the third time that year by 25 basis points (0.25%) to avoid a recession. This caused excitement in both the US and Indian markets. The day after the rate cut, India’s Sensex (stock market index) hit a record high.

If we specifically focus on why India benefits, the reason is that a US Fed rate cut brings more foreign investments. When US interest rates are low, foreign investors often look for better returns in other countries. India, being a growing economy, offers this opportunity to earn higher returns, which makes it attractive to foreign investors.