The Federal Reserve's December meeting signaled a potential pause in the rate-cutting cycle, with rates now at 4.25-4.5%. This has significant implications for emerging market flows and the Indian rupee. Here's our analysis.
Fed's Current Stance
After 100 bps of cuts in 2025, the Fed is now in wait-and-watch mode. Inflation remains sticky above 2.5%, and the labor market is resilient. Markets are now pricing only 2-3 cuts in 2026, down from 5 cuts expected a few months ago.
Impact on EM Flows
- Higher-for-longer rates in the US reduce the attractiveness of EM carry trades
- Dollar strength typically pressures EM currencies and equity flows
- India's relatively high real rates provide some buffer
- Domestic flows continue to offset FII selling in Indian markets
Rupee Outlook
The rupee has depreciated 4% against the dollar in 2025, and we expect continued pressure in H1 2026. Our base case is USDINR at 85-86 by mid-2026. RBI intervention will continue to smooth volatility but won't prevent the trend.
Investment Implications
For Indian equity investors, the Fed pause is a mixed bag. While FII outflows may continue, domestic liquidity remains robust. Focus on companies with domestic revenue exposure and pricing power. Export-oriented sectors like IT benefit from rupee weakness but face demand headwinds.
Our Positioning
We maintain our overweight on domestic-focused financials and consumption names. Stay cautious on FII-heavy names with rich valuations. Consider adding gold as a hedge against currency and global uncertainty.