You can contact the author (Teguh Hidayat) by email, The author live in Jakarta, Indonesia.

See my pictures in Instagram, @teguhidx.

Fed Rate, and Its Influence Towards the JCI

On Thursday, March 19, 2015, chairwoman of Federal Reserve, Janet Yellen, said that the Fed (a popular term for Federal Reserve, which is the Central Bank of the United States of America) is not in a hurry to raise its benchmark interest rate, or known as the 'Fed Rate'. Shortly after the statement was released, stock indices in Europe and Asia increased significantly. Prior to the statement, investors in Europe and Asia, including Indonesia, were concerned that if the Fed raised the Fed Rate, then the foreign funds in the local stock markets will be withdrawn to be placed in the US. In the view of global investors, if the benchmark interest rate was higher, then investment in the United States will offering higher yields, while on the other hand the risk is still considered to be very low because the US is a country with the largest economy in this world.

And if foreign funds come out from the stock market of Indonesia, the Jakarta Composite Index (JCI) will likely drop at least in the short term. However, it has not happened, at least for now. But you might wonder, what is the Fed Rate? And how it affects the JCI?

Fed Rate, or the Federal Reserve's interest rate, is approximately the same with BI Rate (more explanation read here) where it is the interest rate for one year set by the Fed as a benchmark for interest rates on loans and deposits for banks and financial institutions throughout the US. To be simple, when Fed Rate rises, the interest on loans and deposits in banks and other financial institutions can rise also. If the rate on deposit in banks in the United States rose, then it will attract investors from all over the world to put their funds in forms of savings/deposits in the US. Not only interest on savings, when Fed rate increases, the interest on the bonds issued by companies in the United States will also usually go up. If we take the example of BlackRock, the world’s largest asset management company based on New York, USA, they put the majority of their portfolio in bonds rather than equities (53.3% versus 43.5%, the rest is in the form of money market instruments, including deposits). So if the Fed rate rises, BlackRock will likely withdrawn at least a part of their investment from countries outside the United States (including from Indonesia, if they also put a small portion of investments here) to return to their home country.

Logo of BlackRock, the world's largest asset management company with US$ 4.7 trillion of asset under management as of February 2015

Before the release of Ms. Yellen’s statement on last Thursday, there was a speculation that the Fed will raise the Fed rate in the near future, and that speculation arises only because the Fed rate was already on a very low level, which is 0.25% since December 2008, and it has not been raised back until today. Back in 2008, the Fed deliberately suppress the rate to its lowest level at 0.25% because the US economic growth was very low, even negative.

Because, just like the interest rate set by the central banks of other countries around the world, the determination of Fed Rate also aims to make a balance between inflation rate and economic growth in the US. To be simple, when the Fed Rate is lowered, banks in the United States will be 'forced' to extend credit to companies, etc. Because if they just want to play safe by placing their funds at the Fed (the risk of bad loans at the Fed is very small, because it is guaranteed by the US Government), then they will only accept a very, very small interests, which is 0.25% per annum, so they better use their funds appropriately, by disbursing loans to employers/companies. And when the companies receive loans from the bank, they will use it to set up factories, etc., which then create jobs, and ultimately grow the economy as a whole.

Actually, when the US experienced a crisis in 2008 – 2009 where the country had a negative economic growth, the Fed rate shall relegated to a further lower level. However, since the Fed rate can not be set at zero percent let alone negative, the Fed used another instrument namely quantitative easing (QE), whereby the Fed itself that print new Dollar money and distribute it to the US economy, in the hope that it will facilitate people to make buying and selling, and ultimately grow the economy. About the QE, read it more here.

On the other hand, when the banks extending credits in large, and the Fed itself also print new Dollar money through the earlier QE program, then the amount of money that is circulating all over America will increase significantly so that it could cause an increase in inflation. That's why, when the US economy again growth positively, while on the other hand the inflation rate also rose, the QE program can be stopped or halted (we call it tapering, read the explanation here), and the Fed rate can also be raised so that the rate of inflation could down to a safe level.

And now, based on the latest data from the US Bureau of Economic Analysis, the US economy grew 2.4% in 2014 (year on year), and it was much better than the peak of the global crisis in early 2009, where the growth was negative 4.2%. But interestingly, the rate of inflation was still maintained at a very safe level, ie negative 0.1% (year on year, not monthly) aka deflation as of January 2015, the lowest since 2009. Based on this fact, the statement of Ms. Yellen that the Fed will not rush to raise the Fed rate can be explained. If the rates of economic growth and inflation are both showing good numbers, then why should the Fed raises the Fed rate?

However, because the Fed rate is already at the lowest level which is 0.25%, and it has been there for years, then it is only a matter of time before it would be raised back, and it could rise to any levels. Because even though the Fed rate at this point seems very low compared with the rate of any central banks in developing countries (including Indonesia, with 7.5% of BI Rate), but in the past the rate had also been set at high positions, as high as 20% at the beginning of 80’s. So as already mentioned above, when the Fed Rate eventually began to rise, it may continue to rise to any levels, not only to 0.50% or 0.75%, but can be more than that.

The question is, when the Fed Rate is eventually go up, then how it impacts the JCI?

In theory, as already mentioned above, when the Fe rate is raised then the investors who placed their funds in countries outside the United States, including Indonesia, will be poured out to New York and surrounding areas. And when that happens then the JCI will likely dropped.

However, that was only a theory. And what about the facts in the field? Well, let's just take a look at the data. Here are data of Fed Rate since 1997 until 2014, plus the data of net foreign buy on the Indonesia Stock Exchange (IDX), and increase/decrease in JCI in one year.

Fed Rate
Net Foreign Buy
JCI Growth

  1. Fed Rate is at the end of the respective years
  2. Net foreign buy is in trillions of Rupiah (at the current exchange rate, 1 trillion Rupiah is about US$ 80 million), while JCI Growth is in percent per year

Take a look. The key word here is, if the Fed rate rises, then the foreign funds should be taken out from the market and the JCI would fell. But is that really the case? Here we go: In 2000, the Fed rate rose from 4.75% in the previous two years, to 6.50%. But in 1999 and 2000, the foreigners still recorded a net buy on IDX, ie Rp12.1 trillion in 1999, and Rp0.8 trillion in 2000. Interestingly, JCI moved in the opposite in the two years, where it rose 70.1% in 1999, but dropped 38.5% in 2000. Thus in the case of 1998 – 2000, the theory that the increase in Fed rate will lead to foreign net sell and JCI would down, did not apply.

Then in 2004, the Fed rate again increased from 1.00 (in 2003) to 2.25%, and continued to rise until it reaches 5.25% in 2006. However, between 2003 and 2006, JCI rose continuously with a very significant increase in each year (an average of more than 40% per year), and recorded a foreign net sell in 2005 only. After 2006, the Fed rate continued to fall until it reaches the lowest point 0.25% in 2008, which isn’t changed until today. But in 2008, the JCI was fell by more than a half. And in 2013, when the Fed Rate was still unchanged at the level of 0.25%, the foreigners instead recorded a highest net sell on the IDX, and at the year the stock index edged down 1.0%.

My point is, I did not said that the change of Fed rate does not affect anything towards JCI. However, the Fed Rate is only one of the many factors that affect the JCI. The other factors are the change in the BI Rate, inflation, economic growth, the performance of the listed companies, the fluctuations of Rupiah’s exchange rate, the valuation of JCI itself, government policies, aaaaand so on, where some of the factors are affecting the JCI more than just the Fed rate. At the end, the Fed Rate is only a factor that comes from the outside of our country, which is not directly related to the fundamentals of the Indonesian economy.

So does that mean that if Fed Rate is increased later, the composite index will not go down? Well, not necessarily. Based on experience, the most influential factor to the fluctuations in JCI is the valuation of JCI itself (see explanation here). Most people say that the drop in JCI in 2008 was due to the impact of the global crisis, and it is indeed true. But you must also note that in 2007, after the JCI continued to rise for four consecutive years, its valuation was very, very high, where the average PER of all shares on the Stock Exchange had touched the figure of 21 times, or well above the normal level of 12 – 14 times. So we might say that the issue of global crisis is merely a trigger to break the bubble, which from the beginning was ready to explode at any time.

The problem is, when this article was written, the average PER of JCI is 18.5 times, or already quite high, although not as high as when the JCI reached the level of 2,800 in 2007, or when the JCI reached the level of 5,250 in mid-2013. So in term of valuation, the JCI is still have a little room to rise further, but in the end it will come down to return to its normal level, although we would never know when it will happen. However, if the index is still continuing its gains until the PER reaches 19 times, for example, then when the Fed Rate is eventually raised, it would be a very good trigger for JCI to fall down. And if the other factors also 'support' the correction, for example if the listed companies have a not-too-good financial performance in the first quarter of 2015, the Indonesian stock market will certainly enter a period of bearish where it would be an opportunity for the bargain hunters to buy blue chip ‘goods’ at low prices, just like a few months ago when we bought UNTR at discounted prices. So, take your seat and wait!

No comments: