FIIs are waiting for a valuation reset and an easing in global interest rates

Financial analyst works on a computer with a multi-monitor workstation showing real-time stock, commodity and currency charts. Businessman works at night in the city office of the investment bank. istock photo for BL | Photo credit: GORODENKOFF

Yes, a sustainable return of FIIs at some point in the future is inevitable, but that is likely to happen only if certain conditions prevail in 2026 or later. There is uncertainty about the timeline, but there is a lot of clarity about the conditions that must apply. If they are to return on a sustained basis, as they have done for much of the previous decade, the mathematical laws must support this. Currently, these laws are not supportive, even though there have been some views recently that the ‘QE’ initiated by the US Federal Reserve after the last FOMC meeting on December 10 can bring back FII flows.

The math

For much of the past decade and early 2000s, one of the most dominant themes in stock investing has been TINA, or the “there is no alternative” mantra. And that was true: what do investors buy when long-term bonds yield zero to two percent or in some cases are even negative in developed economies? This created what can be called a ‘hunger for yield’, which saw stock valuations gradually rise between 2010 and 2020. For example, the Nifty 50 PE (trailing) rose from a range of 14 to 18 times for much of 2011 to 2014 to consistently trading at 20 times or higher from 2015 to 2020. During both phases, while it occasionally traded outside this range, these were more exceptions. Apart from improving investor sentiment and fundamentals, a global liquidity wave was also a factor that made investors comfortable with higher valuations. Relative appreciation played a role.

The difference between stock returns (1/PE) and bond returns for an FII was too good to ignore, even when currency risks are taken into account.

This math has changed in recent years (see chart). With global bond yields soaring, the risk-reward ratio for an FII to buy Indian equities is at its worst level in many years. This math is simple and difficult. TINA has been replaced by TAMA – there are many alternatives, including government bonds!

For this to change, Indian market valuations need to fall (could happen due to strong earnings growth, or through a correction, or both) or bond yields in countries like the US.

Japan and Germany should refuse for the right reasons. Their bond yields can fall due to two factors: one, inflation is overcome and bond watchers gain the confidence to buy long-term bonds (which will bring rates down), or two, there is an economic slowdown or geopolitical issue that triggers a flight to safety, resulting in the purchase of government bonds. While the former will be good for FII flows into India, the latter will not.

But what about the ‘liquidity surge’ resulting from recently announced Fed actions? Won’t that drive down bond yields?

The new ‘QE’

For starters, the Federal Reserve calls this reserve management, because it only buys short-term bonds. But critics argue that any cash injection by the central bank is a form of quantitative easing (QE). In the past, QE money was typically used to buy long-term government bonds. QEs have historically been positive for equities.

While inflation is still above target, the Fed emphasizes that this liquidity injection was necessary to ensure that the Fed Funds rate remains within the target range.

In recent months, the target range of the Fed Funds rate has been tested in markets as financial institutions in need of liquidity have in some cases been unable to lend within the target range. Interest rates throughout the economy are set based on the target range, and if that range is exceeded, it could impact the Fed’s goals.

In September 2019, the US financial system experienced a repo market crisis, when the repo rate on transactions between financial institutions for liquidity management rose significantly above the Fed Funds rate. While the fed funds rate is the rate at which banks borrow from each other (usually unsecured), the repo rate is the rate at which a broader group of financial institutions borrow from each other using high-quality collateral.

Given that the repo transactions are backed by high-quality collateral, the Fed Funds rate is expected to be monitored very closely. However, when there was an unexpected tightening of liquidity in the US in September 2019 due to withdrawals of deposits for tax payments, large Treasury issuances and some other factors, it resulted in instances where overnight rates rose as high as 10 percent in short cases, while the Fed Funds rate ceiling at the time was 2.5 percent.

Therefore, the reserve management or QE (whatever you may call it) that the US Fed is now implementing is intended to ensure an ample reserve regime, as the signals about the tightening of liquidity now gave the atmosphere of September 2019.

Despite interest rate cuts and ‘QE’, US long-term bond yields have barely budged. This quantitative easing, which aims to prevent a liquidity drain rather than provide a flow, may reduce upward pressure on long-term interest rates, but is unlikely to bring them down unless fundamentals warrant it.

Published on December 20, 2025