The US Federal Reserve reduced its overnight rate – the rate at which banks can borrow from one another – by one percentage point from September to December 2024. Currently, markets expect further cuts in the coming months.
The Fed’s next review meeting is scheduled for 17 September. According to the CME FedWatch Tool, the probability of a 25-basis-points (bps) rate cut that day is 85%. It also predicts two or three 25 bps rate cuts by December 2025, and a 200-bps drop in the Fed funds rate by December 2026.
The reason for these expectations isn’t to do with an easing of inflation, but rather a hit to the US economy from President Donald Trump’s tariffs.
How does all this affect your portfolio?
Fed rate cuts affect your investments in several ways but aren’t a reason to overhaul your portfolio entirely. Some tweaks at the margin are all you need.
A drop in interest rates is positive for equities as money is available for cheaper. When bond yields in the US are relatively low, less money flows there, improving the situation for other markets. Often, a lowering of interest rates by the Fed can cause the Reserve Bank of India to cut rates, too. However, with the RBI having already cut the repo rate by one percentage point in August, chances of more cuts in the near future are slim.
Fed rate cuts have an impact on the rupee, too. When US interest rates fall, the dollar is expected to weaken over the medium term. The strength of the dollar is measured using the dollar index (DXY), which compares it to a basket of six global currencies with defined weights. A fall in DXY is thus positive for the rupee.
However, the rupee is currently under pressure owing to tariff issues and may weaken further against the dollar. This has a mostly adverse impact on your portfolio, thanks to a concept of ‘imported inflation’. The landed price of our imports is priced in dollars and multiplied by the exchange rate. The weaker the rupee, the higher the landed price, which adds to inflation. A weaker currency is generally bad for the external sector.
Having said that, rupee depreciation can benefit your investments in two situations – if you’ve invested in gold or in foreign assets.
The value of your gold investments grows when the price of gold increases but also when the rupee depreciates. Having some exposure to gold thus allows you to benefit from potential currency depreciation.
Broadly, there is an inverse relation between Fed funds rate and gold prices. Historically, when the Fed cuts interest rates, the price of gold price usually increases. Given the geopolitical uncertainties and the fact that a rate cut is extremely likely this month, there is a case for allocating 10-15% of your portfolio to gold.
NRIs, lock in your FCNR rates
Another outcome of the Fed easing interest rates is relevant for non-resident Indians (NRIs). Rates on foreign currency non resident (FCNR) deposits have been easing for the past year or so and are currently are fairly attractive. Banks decide FCNR deposit rates based on factors such as currency, tenure, specific bank policies, and interest rates in the home country.
The relevant benchmark rate in the global context used to be the London Inter Bank Offer Rate (LIBOR). Nowadays, LIBOR has been ditched in favour of the rate in the relevant country. For the US, this is the secured overnight funding rate (SOFR). It became the primary alternative to LIBOR after regulators determined LIBOR was vulnerable to manipulation.
The SOFR rate has eased considerably over the past year or so, and there is a correlation between the SOFR rate and FCNR rate offered by banks. Given that the US Fed is likely to cut interest rates, SOFR is likely to dip further. It’s therefore advisable for NRIs to lock in the current FCNR rate.
Joydeep Sen is a corporate trainer (financial markets) and author.
