Talks of taper tantrum are re-appearing, but the US Fed is re-assuring in its approach!
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Taper Tantrum in financial markets - An analysis
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- Fed's QE and policy normalisation: The US central bank - Federal Reserve - supported the economy since 2008, through an aggressive bond-buying programme. That is called the QE - Quantitative Easing - and pushed liquidity into the market. When the Fed talks of slowing reducing the QE programme, and one day ending it, it is a reflection of monetary policy normalisation.
- Taper tantrum: A lot of liquidity pumped by the US Fed moves around the world, and some of that comes into emerging market stocks. So when the Fed talks of normalisation, markets get scared of large-scale outflows of dollars. That "tapering talk" leads to markets behaving erratically in a "tantrum".
- Taper tantrum of 2013: The Quantitative Easing by Fed involves - (a) purchasing longer-term securities from the open market in order to increase the money supply, and (b) encouraging lending and investment by interest rate cuts.
- After the 2008 global financial crisis, to increase money supply in the economy, the US Fed introduced Quantitative easing programmes. It was aimed at increasing lending by commercial banks and spending by consumers.
- The US economy and labour market conditions recovered well after 2010. Eventually, the Fed began considering exit from the easy money policy by the end of 2013. So, the Fed followed a "Taperin" i.e a system of slowly reducing the amount of money the Fed puts into the economy.
- The announcement in 2013 led to a sudden sell-off in global stocks and bonds.
- Why so? Because when yields on the ultra-safe US treasuries rise, investors have reduced incentive to invest in riskier assets such as equity.
- The US stock market dropped around 4% immediately after the announcement, and bond yields surged. The impact was felt globally as foreign investors pulled money out of bonds of emerging economies, triggering capital outflows and currency depreciation in many emerging market economies including India.
- The subsequent widening of current account deficit (CAD) eroded the forex reserves that the RBI had built till then. It hurt the UPA-2 government badly.
- Apprehension in 2021: In the wake of the pandemic and its economic implications, U.S. Fed again started massive bond-buying programmes in 2020 to infuse liquidity. It pushed down the interest rates, to allow banks to offer cheaper loans, thereby stimulating economic activity. With economic recovery, the US Fed is aiming for a gradual reduction of this quantitative easing programme. This has led to fears that the move could resemble the “taper tantrum” of 2013.
- Massive footprint: Since global investments are driven in a large part from America (almost half the investor funds), the Fed funds rate is critical for global investors. Asset buying sentiment fuelled by the ultra-low interest rates in the US is the norm for today.
- Once rates begin moving up, investors who have borrowed in dollars to invest in assets globally will sell these assets to pay back the dollar loans. This can de-stabilise markets.
- India will see the impact in FPI flows. The FPI flows shrunk from 2015 to 2018 when the Fed was tightening its monetary policy. In contrast, the net inflow was more than Rs.1,70,000 crore in 2020, linked largely to Fed funds rate being close to zero. Now, again, FPI money is likely to move back to US treasury securities. The Indian G-secs and the rupee could witness volatility once the Fed rate hike cycle begins.
- Indian stocks: The impact on Indian equities may be negligible, as seen during the first taper (2013). Today, domestic institutional investors such as mutual, insurance and pension funds can step up the buying. With a large retail investors presence in stock markets now, large FPI outflows may not hurt the markets much. (that wasn't so in 2013)
- Fed realises it: The chaos of 2013 spooked the Fed so much, that it has repeatedly tried assuring the market by saying it would be transparent in its move now!
- EXAM QUESTIONS: (1) Explain the concept of Quantitative Easing (QE). How does a central bank push liquidity via QE? (2) What is "taper tantrum", in context of US Federal Reserve? Explain. (3) Wht should Indian stocks be affected if the US Federal Reserve raises policy benchmark rate? Explain technically.
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