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Why are Global Markets So Obsessed with the US FEDs Rate Cut Announcements?

Indian markets witnessed a volatile day on Wednesday (March 20th) with Nifty plunging 200 points during the day to finally close in green, with trivial gains. The volatility was sparked in anticipation of a major global event - the FED’s announcement on interest rate cuts, happening tomorrow. But what makes the market so obsessed with the US Fed’s decision? Let’s try and find the answer in the explanation given ahead.

Why does the FED matter?

To begin with, let’s first understand - what is FED and why does it matter? In simple terms - FED is the US equivalent to RBI in India, meaning it is responsible for setting and monitoring the monetary policy, regulating the banks, maintaining financial stability, employment, and more. All things considered, it can be said that the Fed holds the key to all financial matters happening in and around the US economy. Since the US is the world’s largest economy, any decision that the Fed imposes or amends, impacts directly on the global front.

Now, coming to the second most important question - why does it matter? Like the RBI which decides what interest rates will be applicable on loans, or how the economy will tackle inflation by choosing to increase or decrease the prices of some commodities or services, Fed also functions the same way. The only difference is - while RBI regulates the Indian market, FED regulates the US markets.

The US dominates the global markets, because it acts as a creditor. This means - the US economy supports other economies by providing credit (loans) for various purposes. The U.S. is a significant contributor to international financial institutions like the World Bank and the International Monetary Fund (IMF). The U.S. currency - the Dollar with its status as the world's primary reserve currency effectively titles the US economy as a global banker. Many countries hold substantial amounts of their foreign exchange reserves in U.S. dollars, and international transactions, including trade and loans, are often denominated in dollars. This dominance provides the U.S. with significant economic leverage and the ability to influence global economic conditions.

With these many dependencies, the US acts as an anchor in the global financial system. So, when the Fed announces a rate cut or hike, it's not just a domestic policy change; it's a signal that ripples through the global economy in several ways

How does the FED’s rate cuts affect the global market?

Global markets are wheeled by sentiments, and the FED steers the sentiments. Imagine if the FED announces a rate hike in borrowings for banks and financial institutions. Since the banks have to pay more interest on their borrowings, they will start charging more to their borrowers, which includes businesses and retail individuals. When businesses have to pay more, they start charging higher prices for their services. India, as a borrower of services from the US, will have to pay more and that too in dollars. Because it costs more for India to buy things from the U.S., prices in India might also shoot up. When prices go up, people tend to spend less because things are more expensive. Increased prices will lead to fewer spendings and fewer spendings will lead to more liquidity - since people will try and save the amount in safer units like - banks, bonds. This is how the FED controls the global economy. While, the above given is just a simple explanation, detailed effects of the rate cut announcements by the Fed are discussed ahead:-

1. Fed influences global interest rates and investment flows

The Fed sets the federal funds rate, which is the interest rate at which banks lend to each other overnight. This rate indirectly influences other interest rates in the economy, including for mortgages, loans, and savings. Changes in the federal funds rate can influence inflation and economic growth, which is why it's closely watched as an indicator for the stock markets globally.

2. Influencing currency valuation

Fed rate decisions influence the value of the U.S. dollar. A rate cut can lead to a weaker dollar, making U.S. exports cheaper and more competitive abroad but increasing the cost of imports and potentially leading to inflation. On the other hand, a rate hike can lead to stronger dominance of the dollar, making imports cheaper but exports expensive for foreign buyers.

3. Global borrowing costs

As mentioned previously, many international loans are denominated in U.S. dollars, and changes in the Fed's interest rates can affect borrowing costs worldwide. A rate cut might lower the cost of servicing dollar-denominated debt for other countries and corporations, easing financial pressures. A hike, however, can do the opposite, making debt more expensive to service and potentially leading to financial strain.

4. Governing economic sentiment

The Fed's actions are closely watched as indicators of the U.S. economic outlook. A decision to cut rates might be seen as a move to stimulate a slowing economy, which might bring positive global economic sentiments and investor confidence. Markets may react to what the Fed's decisions imply about the health of the global economy, not just the U.S. economy.

5. Commodity prices

Many commodities are priced in U.S. dollars, so Fed decisions that affect the dollar's value can also impact commodity prices. A weaker dollar, following a rate cut, can make commodities cheaper in other currencies, potentially increasing demand and prices. This can have widespread effects on countries that are major exporters or importers of these commodities.

While the obsession doesn’t end here, these are certainly some of the most important points an investor and a trader should remember. With the US Fed ready to take the centre stage tomorrow, it's understandable why global markets are hung on listening to every word from the Fed's announcements. The anticipation builds because these decisions have a domino effect that goes beyond the US borders, influencing everything from inflation rates in other countries to the overall global economic sentiment. Whether the decision is to cut rates, hold steady, or increase them, the implications will be carefully analyzed and felt across the globe, highlighting the pivotal role the Fed plays in not just the US economy, but the world's.