Dalal Street’s Thanos: Fed Taper

A Research Article by Yatharth Dhingra

INTRODUCTION

Core inflation in India rose to a 6 month high of 6.08%, while the WPI inflation rose by 5.74% to a daunting record high of 14.56% by December 2021. In the US, the annualized inflation rate stood at around 7%, its highest since 1982 (40 years). During the same time, the RBI also started selling ₹9000 crore worth Govt securities monthly in the secondary market, whereas the US Fed started selling $30 Billion ( or 2.3 Lakh crore rupees ) worth treasury bonds monthly. Interestingly enough, during this very same period since November, Sensex dropped about 3500 points or a dismaying 5.2% net, whereas Nifty dropped about 1200 points or a blood-shedding 7% net. Nasdaq and Dow Jones also fell till December by 1-3 percentage points. Intriguingly, the value of the rupee to USD depreciated from 1$= ₹73.91 at the start of November to 1$= ₹76.21 by mid-December, and is estimated to fall 3% more by early 2022, as per fitch global analysis. This economic game of 4 variables: inflation, bond prices, stock market, currency valuation, and their above-mentioned fluctuations, might look natural and coincidental when viewed individually, but such an assumption is untrue. The general public is driven by the price of commodity considerations, market participants are driven by profit, and the central authorities are driven by stability and growth. However, what makes this consideration interesting, is that the driver of one agent is impacted, and in some instances even determined, by the incentives of the other agent. Price consideration of public is determined by the central bank’s stability and growth policy. Market fluctuations are in turn heavily influenced by price considerations in the economy, etc. The application and impact of these drivers extend far beyond the 3-4 agents given above and affect every economic variable including currency, imports, exports, fiscal deficit, forex reserve, etc. Once the core mechanism is understood, making the auxiliary impacting links becomes intuitive.

The aim of this article is twofold. It is to elucidate the working of the RBI in response to degrees of inflation with respect to bond issuance and also to give an economic mechanism on how and why does bond tapering by the central bank impact domestic and foreign stock markets in such a drastic manner.

Quantitative easing: Liquidity infusion

At any point in an economy, the central bank can pump liquidity into the economy, through 2 major policy ways: It can decrease the interest rates because cheaper credit decreases the cost for borrowers to invest or, it can ramp up the purchasing of bonds, famously known as quantitative easing.

When the government decides to purchase bonds in a large quantity, it increases the prices of bonds, which decreases the coupon rate on the bonds. Considering the market interest rate (which we assume as the cost of purchasing the bonds) to be constant, the return that the individual now derives on the bond (which is the coupon rate) is lowered with respect to the market interest rate, thereby making bonds a less attractive investment opportunity for investors with respect to other asset classes, thereby leading to a major sell-off by the market, successfully achieving the goal of the government to purchase bonds.

Bond Tapering: Liquidity mopping

After a sustained period of pumping liquidity in the economy, it becomes crucial for any government to scale back and mop the excess, in order to prevent inflations breaching key levels, leading to major currency devaluation, inability to import, and in extreme cases, an economic breakdown like in the case of Germany, Zimbabwe, Greece, etc.

Bond tapering, therefore, refers to the scaling back or tapering the purchasing of bonds undertaken by the central bank to mop up the excess stimulus in the economy, to reduce inflation levels and bring back price stability in the economy. During this period, the central bank decreases the prices of bonds, which increases the coupon rate on the bonds. Considering the market interest rate to be constant, the return that the individual now derives on the bond is higher with respect to the market interest rate, making bonds an attractive investment opportunity for investors with respect to other asset classes, leading to a major buy off by the market and successfully achieving the goal of the government to sell bonds and mop up excess liquidity.

IMPACTS OF TAPERING ON THE STOCK MARKET

We will explain the relative impacts of tapering on stock markets in two different time periods, the global financial crisis of 2008-9 vs the COVID-19 pandemic of 2020-21.

The global financial crisis and the taper tantrum of 2013

In 2013, as the world was coming out of a global financial crisis, the Federal Reserve said it would gradually reduce quantitative easing instituted after the Lehman Brothers bankruptcy in 2008. This would involve slowing the purchase of treasury bonds and reducing the money being pumped into the US economy. From 2008 to 2013, the Fed had tripled the size of its balance sheet from $1 trillion to around 4 trillion by purchasing almost $2 trillion in Treasury bonds and other financial assets to prop up the market. Investors depended on ongoing massive Fed support for asset prices through its ongoing purchases.

The asset levels held on the Fed’s balance sheet ballooned in the subsequent three years, as seen below:

The announcement, in 2013, of reducing bond purchases by the fed was not received well by investors who responded immediately to the prospect of future decline in bond prices by selling bonds, depressing the price of bonds, and shooting up the yields.

Tapering not only means the end of the central banks’ expansionary policies but also signals the eventual onset of monetary tightening. That means higher interest rates on mortgages, consumer loans, and business borrowing, essentially signalling tighter liquidity. This spiked investors. Considering the fact that the participation of domestic investment was low in the Indian stock market which was controlled by foreign investors, a mass scale pull out by these players led to major

sell-offs, therefore leading to a crash of not only the Indian but many developing economy’s stock markets, coming to be known as the taper tantrum.

The COVID-19 Pandemic

The start of the pandemic saw lockdowns and minimalistic mobility of individuals due to the threat of the virus, meaning that consumer demand and sentiments were at their nadir, along with supply getting stagnated. To revive demand, the economies had to resort to large scale fiscal stimulus which came in the form of interest rate cuts and mass scale bond purchasing.

The US fed purchased about $500 billion in Treasury securities and $300 billion in government-guaranteed mortgage-backed securities from the open market at the start, followed by the June 2020 announcement, when the Fed set its rate of purchases to at least $80 billion a month in Treasuries and $40 billion a month in residential and commercial mortgage-backed securities until further notice.

RBI also announced a staggering 1 trillion rupees ($14 Billion) quarterly treasury acquisition program post-pandemic, which surprisingly surpassed on numerous occasions to inject the degree of liquidity pump needed in the economy.

The 3 graphs below show the quantitative easing programs undertaken in the US, India and the UK respectively to tackle the pandemic :

However, a period of blind market rallies followed this expansion, with Sensex and Nifty breaking all previous records, and recording new highs every day. The reason for this is riding on excess liquidity driving up discretionary spending, spiking demand and hence rallying indices. This was also seen in the IPO boom that India recorded in 2020-21, showing how foreign as well as domestic investors, backed by higher investment capacity now, are bullish on the growth potential of the Indian economy.

The graphs below give an idea of how the Indian markets panned out during the pandemic with respect to investments:

However, as explained earlier, it becomes a necessity to scale back on the liquidity, in order to prevent the long term weakening of the domestic currency. Following this, starting November 2020, the RBI started selling ₹9000 crore worth Govt securities in the secondary market every month, whereas the US Fed started selling $30 Billion ( or 2.3 Lakh crore rupees ) worth treasury bonds every month as tapering measures to mop liquidity and stabilize prices.

Even though the market did drop by dismaying numbers across the year, the impact of tapering was relatively highly muted on Indian markets as compared to the situation at the time of GFC. The differentiators compared to that period were:-

1. Central bank transparency - What the central banks learned from the 2013 taper tantrum is that market crashes are backboned on shocks. To the extent a piece of information is duly and slowly conveyed to the market over time, the market factors it in through circular dipping of stocks and therefore preventing a crash. In 2013, the announcement to undertake a mass scale aggressive taper came as a surprise to the market, thereby spiking investors. However, compared to the COVID pandemic, the fed reserve chair, as well as Indian FM, started injecting nudges through publications, speeches, etc that a taper is inevitable. Furthermore, its pace has also been kept gradual, to prevent sudden movements by participants. This has substantially reduced its shock value, leading to a balanced response.

2. Increase in long term domestic systematic inflows- Domestic MFs, SIPs, and EPFOs and long term invested retail investors provide a cushion for the Indian stock market which was missing earlier. The domestic players gaining power over the market means that a situation like 2013, when foreign investors selling their stake drove Sensex and nifty to the ground was unlikely in the pandemic as the cushion was provided by a strong and majority class of domestic investment.

However, the foreign investors still hold a big influence over Indian markets, and their investing or pulling out money does drive the market into green or red, respectively. The graph below shows the movement of the Indian benchmark in tandem with foreign investments.