January has turned out to be the cruellest month for the Indian stock markets. A news report I came across claimed that it was the markets' worst start to a year in the last 28 years.

From its peak of 21,207 on January 10, the Sensex has lost about 16 per cent as I write. Foreign institutional investors have pulled out about $3.2 billion over the month.

This sudden bearishness is underpinned by a number of changes in the market dynamic. The most critical, in my opinion, is the de-linking of the local market from US interest rates.

Until recently, declines in US rates invariably saw an uptick in Asian markets (including India) as fund-managers borrowed at cheaper rates and bought high-yielding Asian stocks.

However, this time the unprecedented a one-and-a-quarter percentage point cut in the US central bank's policy rate has failed to bring succour.

This reflects two things. First, there has been a rapid escalation in risk aversion, which has reduced the appetite for all risky asset classes, including emerging market stocks.

The best index of the reduction in risk-preference has been the yen-dollar rate, which has moved down from levels of over 120 in mid-2007 to current levels of about 106. I suggest that local stock market investors watch this rate very closely to get a sense of what the FIIs are likely to do.

Let me just elaborate on this a bit. The Japanese money market, with its exceptionally low interest rates, has been the principal funding currency ("carry currency") for higher-yielding assets across the world. With rising risk, investors sold risky assets and bought back the yen to pay off their yen loans. This led to a rapid appreciation of the Japanese currency. Only a significant depreciation of the yen would signal a change in risk appetite and the possible return of FIIs to our shores.

Second, investors are slowly pricing in dimmer growth and profit prospects for India as the US heads towards recession. Elevated valuations (at its peak the Sensex was trading at a price earning multiple of 22, using projected earnings for a year ahead) have not helped India's case.

The result has been fairly sharp and sustained sell-off by foreign funds. Domestic investors have been more optimistic about India's prospects. If they hadn't been around to support the market, the plunge would have been sharper.

I suspect that the negative sentiment towards Indian and other emerging equity markets will continue for a while. While the jury is still out on whether the US is already in a recession or not, the US Fed's somewhat panicky policy gestures seem to suggest that it is preparing for the worst.

That might, ironically, bring global funds back to America. Past recessions have shown that investors don't flee American shores in times of crisis. Instead, they start buying the safest of the safe assets, US treasury bonds, with a passion. The fact that the dollar has tended to appreciate against major currencies over most recessions reflects this flight to safety.

Indian stocks are likely to remain in the dumps for a while but I don't think it is the beginning of a prolonged bear market. While I have argued against the notion of decoupling --  the theory that business could go on as usual in Asia even if the US economy were to slide -- it is unlikely that economies like India or China will see a severe slowdown.

Thus company earnings growth could disappoint if the effects of the US slowdown spill over but it is unlikely that they will plummet. Stock prices may fall more but this will make stock valuations look increasingly attractive relative to growth prospects.

The US Fed's response to the apprehension of recession is to cut interest rates relentlessly. Other central banks might not match the Fed, cut for cut, but it's likely that they will pare rates to a degree.

Thus by the middle of the year or perhaps another quarter ahead, investors would be looking at significantly lower cost of borrowing leverage in most markets.

When investors get the first signal that the US economy is bottoming out (a couple of months of falling unemployment rates, for instance), their risk appetite will rise sharply.

Rising risk appetite and low borrowing costs can turn out to be a heady mix for markets like India where valuations have corrected and growth has, as I anticipate, sustained at fairly healthy levels.

In short, the Indian market might thus be one of the first to gain in the advent of resurgence in preference for risky assets.

When could this happen? The US Fed has taken a bit of flak for pandering to the whims of the financial markets. However, its strategy of cutting rates relentlessly is likely to buoy not just the financial markets but the real economy as well somewhat soon.

There are various channels through which lower rates could work. Adjustable rate mortgages, the bane of cash-strapped US households, could reset at significantly lower rates and set off benign income effects.

As risk-free treasury bond yields plummet, banks might just start to jettison their government bond holdings and start lending to the real sector instead. I will thus not be surprised if the US economy finds a bottom by the third quarter of 2008.

I am not suggesting that America's problems will disappear overnight in the third quarter. Problems could linger both in the financial markets and the real sector but one could just see the mix of data and news emerging from the US turning favourable. This could be the turning point for Indian equity markets.

The author is chief economist, HDFC Bank [Get Quote]. The views here are personal.