Closing the tap. Taper is coming, should you worry?

The manner in which the US Federal Reserve is easing the financial market into the taper cycle reminds one of a parent gently preparing a reluctant child to do something it does not want to do. The idea has to be first introduced, then it needs to be casually mentioned every now and then so that the child knows that it is inevitable. Then finally, the date has to be given, well in advance.

In the last two Federal Open Market Committee meetings, the Fed Chair, Jerome Powell, has been trying to assuage markets by saying that accommodative policy will continue for as long as needed. But, at the same time, he has been acknowledging that the Fed is beginning to discuss the taper timeline.

However, the July FOMC minutes has made it clear that the tapering of monthly bond purchases is just months away from now. The minutes showed that most of the committee members were of the opinion that it could be appropriate to start reducing the pace of asset purchases this year because they saw the Committee’s “substantial further progress” criterion as satisfied with respect to the price-stability goal and as close to being satisfied with respect to the maximum-employment goal.

Financial markets reacted negatively, immediately after the release. But they have recovered smartly since then. What will be the impact on financial markets once the taper actually begins? To get the answer, we need to look at the famous taper tantrum of 2013.

The tantrum in 2013

The Fed’s balance sheet was quite slim prior to the global financial crisis, at $870 billion in August 2007. With successive quantitative easing programmes infusing money into the economy post-2008, its balance sheet swelled to $4.5 trillion by early 2015.

The US economy and labour market conditions recovered well after 2010, and the Fed began considering exit from the easy money policy by the end of 2013. Financial markets that were riding on the wave of liquidity infused by the QE programmes, were unaware of the Fed’s deliberations. However, the then Fed Chair, Ben Bernanke, let slip the Fed’s intention in a response to a question in a Congress’ Joint Economic Committee hearing. He said, “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the next few meetings ... take a step down in our pace of purchases.”

This statement caught the markets off-guard, leading to the notorious taper tantrum. The US stock market dropped around 4 per cent immediately after this announcement, bond yields surged and there was turmoil in the currency market. The impact was felt globally as foreign investors pulled money out of bonds of emerging economies, creating turbulence in currency markets as well.

Monetary policy normalisation of the Fed involves three basic steps. One, reducing the quantum of monthly bond purchases to take it to zero. This phase lasted from January 2014 to September 2014 in the previous taper cycle. Two, a specific amount of bonds are not rolled over every month, thus reducing the amount of outstanding bonds. This took place between October 2017 and August 2019.

The third and the most important part of the normalisation is increasing interest rates. The rate hike cycle was very slow between December 2015 and January 2017. But it became more aggressive in 2017 and 2018, with the cycle peaking at 2.41 per cent in March 2019.

Bond markets seem to react only in the third phase. The US 10-year bond yield declined between November 2013 and June 2016. The yields however began hardening once Fed funds rates began moving higher in 2017 and 2018.

US stocks were in fine fettle all through the taper and rate hikes as well. The S&P 500 index gained 97 per cent between May 2013 and January 2020. The Sensex too gained 105 per cent in this period.

Currency market too seems to react more when Fed funds rate is hiked. The dollar index weakened slightly between May and December 2013, following Bernanke’s statement. But it started strengthening from January 2014, to hit the peak of 102 by October 2016. But the greenback has been sliding lower since then.

The likely impact this time

The cat was set among the pigeons by the FOMC minutes of the July meeting. There was the usual hardening of bond yields and stock market correction, but it was very shallow and quite short-lived. The US 10-year bonds have hardened just 50 basis points (bps) since the release.

The S&P 500 declined 1 per cent on the day of the release, but recovered from the next day and is currently at fresh highs. The Sensex also lost less than 1 per cent and is currently hitting new highs. The rupee whipsawed, but its value is unchanged since the minutes were released.

The relatively milder reaction of financial markets, when compared with 2013, is due to the Fed playing its cards carefully and preparing the financial market participants well in advance. Market participants are savvy enough to understand that the Fed cannot continue to indefinitely pump liquidity when growth is strong and CPI is reading above 5 per cent. Also, return to conservative monetary policy implies that the economy no longer needs crutches, which is good news for equity and bond markets.

That said, the reaction of the markets to the taper in 2014 shows that bond and equity markets take reduction in bond purchases sanguinely, but react adversely to rate hikes. While reduction in monthly bond purchases may not elicit much response from markets, the going will get tough once the Fed embarks on rate hike cycle.

Fed funds rate

The Fed funds rate is critical for global investors due to the asset buying binge fuelled by the ultra-low interest rates in the US. Almost half of the global investor funds originate in the US. 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 deleveraging can de-stabilise markets.

The biggest impact in India will be seen in foreign portfolio flows. Analysis of the FPI flows shows that flows shrunk from 2015 to 2018 when the Fed was tightening its monetary policy. The net inflow of ₹1,70,262 crore in 2020 can be linked largely to Fed funds rate being close to zero.

Also, the Indian G-secs and the rupee could witness volatility once the Fed rate hike cycle begins. With the gap between sovereign bond yields decreasing, FPI money is likely to move back to US treasury securities, weakening the rupee.

The impact on Indian equities may be negligent, as seen during the first taper. That’s because domestic institutional investors such as mutual, insurance and pension funds can step up the buying. Also, with retail investors becoming a force to reckon with in daily turnover, large FPI outflows may not hurt the market much.

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