Markets in Turmoil After Fed’s Cautious Rate Cut!

Our goal with The Daily Brief is to simplify the biggest stories in the Indian markets and help you understand what they mean. We won’t just tell you what happened, but why and how too. We do this show in both formats: video and audio. This piece curates the stories that we talk about.

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In today’s edition of The Daily Brief:

• Fed Surprises with Cautious Rate Cut
• New SEBI Reforms to Protect Investors

Fed Surprises with Cautious Rate Cut

Today's first story is about a big piece of news—the Federal Reserve, or “the Fed,” has cut interest rates by a quarter of a percentage point. This brings the federal funds rate down to a range of 4.25% to 4.5%. For some context, this is the Fed’s third rate cut in a row, and if you add up all the cuts they’ve made recently, it totals a full percentage point.

But here’s the twist—this wasn’t your typical rate cut. In fact, it’s being described as one of the most cautious, or even hesitant, rate cuts we’ve seen in a while. That might sound a bit confusing, so let’s break it down.

Before diving in, let’s quickly go over the basics for anyone new to how this works. The Fed controls something called the federal funds rate. This is the interest rate banks use when borrowing money from each other. When the Fed raises this rate, borrowing becomes more expensive for everyone—businesses, consumers, and investors. This slows down spending and helps cool inflation. On the other hand, when the Fed lowers the rate, borrowing gets cheaper, which encourages more spending and investment, giving the economy a bit of a boost.

So, when the Fed cuts rates, it’s usually seen as a move to support the economy. But this time, the tone of their message was different.

During the announcement, Fed Chair Jerome Powell said something that stood out—it was “a closer call” to cut rates this time. He also pointed out that their policies are now “significantly less restrictive.” In simpler terms, the Fed has already eased up on financial conditions quite a bit compared to before.

Despite cutting rates, Fed Chair Jerome Powell didn’t sound hopeful about more rate cuts anytime soon. Instead, he emphasized caution, sending a clear message to the markets: don’t expect us to keep lowering rates like we did earlier.

The financial markets didn’t take this well. The S&P 500, a key stock market index, dropped nearly 3% in one day—a steep fall. Treasury yields, which reflect the interest rates on government bonds, shot up. For instance, the yields on 2-year and 10-year Treasury bonds rose by 13 basis points each (just to clarify, a basis point is one-hundredth of a percentage point). It’s rare to see bond yields spike this much right after a Fed meeting.

The US dollar also strengthened noticeably. When the dollar gets stronger, other currencies usually weaken, which can impact global trade and investments.

One big shift was in how investors are thinking about future rate cuts. Before the Fed’s announcement, some were betting on another rate cut in January. But after Powell’s cautious tone, those odds dropped to zero. Now, markets expect very few rate cuts in the first half of 2025. This shows just how unexpected the Fed’s message was.

So, the big question is: Why is the Fed being so cautious?

The Fed’s cautious approach seems to be based on updated forecasts for key parts of the economy:

Inflation: The Fed now expects core inflation (which excludes things like food and energy prices that can swing up and down) to stay higher than they previously thought. They’re predicting it will hit 2.8% in 2024 and 2.5% by the end of 2025. That’s still above their long-term goal of 2%.

Economic Growth: In a bit of a surprise, the Fed raised its GDP growth forecast for 2024 from 2.0% to 2.5%. This shows they’re more optimistic about how the economy will perform.

Unemployment: They also lowered their forecast for the unemployment rate in 2025 from 4.4% to 4.3%. This suggests they believe it’s possible to bring inflation down without causing a big increase in job losses—a situation often referred to as a “soft landing.”

One of the key updates from the Fed was the revised “dot plot.” This chart shows where Fed officials think interest rates will go in the future. The new projections now point to just two small rate cuts in 2025, down from the four cuts they suggested back in September.

Source: Morning Star

This was a major shift for markets, which had been expecting a quicker pace of rate cuts. Right now, investors don’t anticipate a full rate cut until late 2025. This signals that interest rates are likely to stay higher for a longer period.

The Fed also made a small technical adjustment by lowering the overnight reverse repo rate (a tool they use to manage short-term interest rates) by 5 basis points to match the lower end of their target range. Powell was clear that this wasn’t meant to signal any policy change, but it shows how carefully they’re managing their tools in this phase.

Interestingly, not everyone on the Fed’s committee agreed with the rate cut. Cleveland Fed President Beth Hammack voted against it, preferring to keep rates where they were. She wasn’t alone—four other Fed officials (who don’t vote this year) also wanted to hold off on cutting rates. This disagreement highlights how tricky the Fed’s job is right now.

Powell explained that while the economy is strong—“in a really good place,” as he put it—the Fed is still worried about lingering inflation risks. He noted that while higher rates are affecting areas like housing, broader financial conditions, such as stock market valuations and corporate bond spreads, remain relatively loose. This disconnect could be another reason why the Fed is approaching things so cautiously.

There’s also a layer of complexity involving fiscal policies from former President Trump’s administration. Powell acknowledged that some Fed officials are factoring in potential effects from policies like tariffs, tax cuts, and immigration restrictions, while others aren’t. This divide shows how uncertain the economic outlook is, making it even harder for the Fed to plan ahead.

Now, let’s get to the big question—what does this mean for people like us? Here’s a simple breakdown:

• Borrowing costs (like home loans or car loans) are unlikely to drop much anytime soon.
• Investors should be prepared for more market ups and downs.
• Businesses might face higher costs, which could eventually impact hiring and wages.

Right now, the Fed is clearly signaling caution. They’re entering what Powell called “a new phase,” where they’ll be very careful and deliberate about future rate cuts. Whether this strategy can bring down inflation without hurting the economy too much remains to be seen. But one thing’s certain—the Fed is keeping everyone on edge.

New SEBI Reforms to Protect Investors

Recently, SEBI held a key board meeting where it announced several changes—19 updates, to be precise. These cover a wide range of areas, including mutual funds, IPOs, and even how companies raise money. But don’t worry—we’ll focus on just four big updates that are the most relevant and impactful. These changes aim to protect investors, reduce misuse of funds, and create a healthier market environment.

What’s worth noting is that these changes aren’t entirely new. SEBI had floated these ideas earlier in consultation papers to get feedback from the public. What’s different now is that these proposals have officially been turned into rules. Let’s dive into each update, step by step, to see what’s changing and why it matters.

1. Fixing the SME IPO Framework

First, what’s an SME IPO? SME stands for small and medium enterprises—basically, smaller companies that need funding to grow. SEBI created a special platform for SME IPOs in 2008 to make it easier for these businesses to raise money. The idea was good, and the platform grew quickly. Today, there are 745 SME-listed companies with a combined market value of ₹2 lakh crore. Impressive, right?

But rapid growth came with problems. Some IPOs showed signs of excessive speculation, where retail investors drove up demand for shares of tiny companies with questionable fundamentals. For instance, a small company with just two Yamaha showrooms in New Delhi had its IPO oversubscribed by 400 times. Another company, Varanium Cloud, allegedly manipulated its IPO to artificially inflate its valuation. These examples raised red flags.

To address these issues, SEBI is tightening the rules to ensure only trustworthy and stable businesses raise money through IPOs. Here’s how:

• Profitability Requirements: Companies must now prove they are stable by showing an operating profit (EBITDA) of at least ₹1 crore in two of the last three financial years. This filters out unproven or speculative ventures.
• Restrictions on IPO Funds Usage: Companies often raise money for things like expansions or paying off loans. However, some misuse these funds or hide their intentions under vague categories like "General Corporate Purpose" (GCP). SEBI now caps GCP spending at 15% of the funds raised or ₹10 crore, whichever is lower. Moreover, IPO money can’t be used to repay loans of the company’s promoters or related parties. This ensures funds are used to grow the business, not for personal gains.
• Rules for Selling Shareholders: Promoters and shareholders selling their stakes during the IPO can now only sell up to 50% of their holdings, and this can’t exceed 20% of the total issue size. This prevents promoters from cashing out entirely, leaving the business vulnerable.
• Public Comments on DRHPs: Before an IPO goes live, the draft prospectus (DRHP) will now be open to public feedback for 21 days. This allows investors to raise concerns early, preventing scams like the Trafiksol case, where public complaints halted a dubious IPO.
• No Mandatory Migration to the Main Board: SMEs can stay on the SME platform even after raising additional funds, provided they meet governance standards. This removes unnecessary barriers for small companies.

2. Tighter Rules for Merchant Bankers

Merchant bankers are the behind-the-scenes players in IPOs and fundraisings. They help companies sell their shares or bonds by managing the process and connecting them with investors. However, sometimes their actions lead to conflicts of interest. For example, Axis Capital, a leading merchant banker, was accused of guaranteeing payments, which goes against SEBI rules.

To clean things up, SEBI is enforcing stricter guidelines:

• Focus on Core Activities: Merchant bankers (except banks and financial institutions) must focus only on SEBI-approved activities like IPO management, underwriting, or mergers and acquisitions. Non-core activities like lending or mutual funds must be spun off into separate companies within two years. This ensures their attention is on the tasks they’re supposed to handle.
• Independence in Lead Management: If a merchant banker owns more than 0.1% of a company, it cannot lead-manage that company’s IPO. This avoids conflicts of interest. They can still participate in marketing the issue, just not as the lead.
• Categorization: Merchant bankers are now split into two categories:
• Risk Control in Underwriting: Merchant bankers cannot underwrite more than 20 times their liquid net worth, reducing their exposure to excessive risks.

3. Simplifying Rules for REITs and InvITs

REITs (Real Estate Investment Trusts) and InvITs (Infrastructure Investment Trusts) are investment vehicles that let people invest in real estate or infrastructure projects, much like mutual funds for property. SEBI’s changes aim to give these funds more flexibility and make them safer for investors.

• Sponsor Unit Transfers: Sponsors (the main backers of these funds) must lock in some units to show commitment. Now, they can transfer these locked units within their own group, allowing for better internal management while maintaining their commitment.
• Hedging with Derivatives: Rising interest rates can hurt REITs/InvITs as they increase borrowing costs. SEBI now allows these funds to use derivatives to hedge against interest rate risks. This protects their cash flows and makes them more stable.
• Investments in Unlisted Equity: REITs/InvITs can now invest in unlisted companies, but only if those companies provide essential services like property management that directly benefit the fund.
• Safer Liquid Fund Investments: Surplus funds can be parked in the safest liquid mutual funds with low credit risk, ensuring stability and better returns.

4. Stricter Oversight on Mutual Funds and NFOs

Mutual funds have seen a boom in new fund offers (NFOs) recently. But this growth brought its own problems, like distributors pushing unsuitable schemes for higher commissions or fund houses raising more money than they could deploy.

SEBI is stepping in with two key rules:

• 30-Day Deployment Deadline: Asset Management Companies (AMCs) must now deploy funds raised through NFOs within 30 days. If they fail, investors can withdraw without paying exit loads. This prevents idle funds and ensures AMCs only raise what they can use.
• Curbing Mis-Selling: During NFOs, distributors often earn higher commissions, leading to mis-selling. SEBI now mandates that for scheme switches, distributors earn only the lower commission of the two schemes. This aligns incentives with investor interests.

These updates may seem technical, but they address real issues in the market. They aim to make IPOs safer, tighten oversight on intermediaries, provide flexibility to REITs/InvITs, and protect mutual fund investors from being misled. By introducing these changes, SEBI is ensuring that the markets are not only fairer but also more efficient and transparent.

For anyone investing in India’s capital markets—whether you're a seasoned analyst or just starting out—these updates provide much-needed clarity and protection.

Tidbits

1. An unusual error inflated India’s trade deficit to $37.84 billion in November due to a double-counting of 50 tons of gold imports. This mistake raises important policy concerns because inaccurate data can lead to poor fiscal decisions and misguided economic strategies. It highlights the need for accurate and reliable data, especially during times of economic uncertainty.
2. In the US, markets took a sharp hit after the Federal Reserve signaled it might not cut interest rates as much as investors had hoped in 2025. The Dow Jones fell by 2.58%, while the Nasdaq dropped 3.56%. Treasury yields rose, the US dollar strengthened, and gold prices declined—all signs of tighter financial conditions and growing caution among investors.
3. Meanwhile, Punjab & Sind Bank successfully raised ₹3,000 crore through a bond issuance with a coupon rate of 7.74%. The issue saw overwhelming demand, being oversubscribed 12 times, even in a market with tight liquidity. This reflects strong investor confidence in public sector bank bonds, supported by India’s focus on infrastructure development and smart pricing by issuers.

-This edition of the newsletter was written by Bhuvan and Kashish

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This post was first published on Substack.