Between the acting of a dreadful thing, And the first motion, all the interim is, Like a phantasma or a hideous dream’
– Brutus, in Shakespeare’s Julius Caesar The unwinding of the US Fed’s QE has been as sensational as the invoking of the same. The Fed had begun this programme in late-2008 and the reason was simple: Low interest rates, on their own, could not restart the economy which had low liquidity as banks were reluctant to lend to one another. By buying back paper from the market, liquidity was induced. There were several misgivings on QE. But inflation remained subdued and did not rise, contrary to expectations. The impact on growth was not too clear, as the GDP did recover to grow by an average of 2.2% in the 4 years following negative growth of 0.3% and 2.8% in 2008 and 2009 respectively. However, one unintended consequence was the explosion in the flow of funds to emerging markets. It was a clear case of ‘carry trade’ where funds could be borrowed at a low cost and then invested in emerging markets which were de-coupled and booming. We all loved it. The shock came in May 2013 when the Fed hinted at unwinding the programme and the emerging markets took fright as funds did an about-turn and distorted the external accounts of countries like Brazil, India, Indonesia, Turkey, and South Africa. The actual tapering began from December when the $85 billion per month buyback of MBS and treasuries was sequentially reduced to $15 billion as of October 2014. Surprisingly, the markets fared better when the tapering actually commenced. Currencies have stabilised and it is back to business as usual. There is just another $15 billion of bonds to be bought up on a monthly basis, after which the Fed would have reached equilibrium. After this point, the economic indicators will decide the Fed’s course of action. The consensus is that near-zero Fed funds rate will continue for some more time and there would be an increase in rates in mid-2015 if inflation becomes an issue and growth stabilises. The unemployment rate too would be critical which in August was 6.1% and 5.9% in September. The removal of QE can be looked at from the point of view of USA and India. In the US, the bond yields movements have been idiosyncratic. Typically, lower QE and the prospect of higher interest rates at some point of time should put pressure on the bond yields. But the yields have responded in a varied manner. The 10-years yield increased from 2.53% in May 2013 to 3.03% in December 2013 and then came down to 2.52% in June and to 2.09% in October 2014, even going below the 2% mark during intraday trade. Clearly, the markets are not expecting the rates to increase any time soon. Also, the movement of funds into bonds has pushed up demand and prices and hence lowered yields. Movement of such funds is also a result of weakening of global commodity prices, especially of crude and gold, hence diverting investments. Crude oil has been down from a little over $100 in May 2013 to the early-80s in October 2014. With the dollar strengthening from 1.36-38 to the euro in June to 1.26-28 in the last month on account of the recovery in the USA—though IMF indicates that growth will be stable at 2.2% in 2014 too, as in 2013—funds are moving back to US treasuries. With fewer treasuries available as the Fed has stocks of about $4 trillion so far, the prices have increased. From now on the approach of the Fed will be important. Will it start raising interest rates? Will it start selling treasuries in the market to mop of funds and hence cure the price rise? The answers are not known and the inflation and employment numbers hold the clue. Till then volatility can be expected in the market. How about our own economy? How vulnerable are we? The Indian economy hit back quite well after the initial slip with action being taken by RBI to shore up forex reserves. The important variable to look at would be the FII investments in debt. This is more likely to be affected than equity as the latter is guided by a different set of factors as the character of investment is different for the two, though there can be substitution at the margin. The trends in such investment in debt are interesting. Following the tapering announcement in May, there were 5 months of net outflows of $13 billion till November 2013. Subsequently, when the tapering actually took place following the December 18 announcement, the FIIs turned buyers for the next 4 months to $6.6 billion. April 2014 witnessed an outflow of $1.5 billion, but after that for the next 5 months there have been continuous inflows of $15.4 billion. These numbers are heartening as the debt market has been attractive to the investors notwithstanding the tapering of the amount. The interest rate differential is important. With our GSec yields being high, at above 8%, and a stable exchange rate, the returns are attractive. This raises some questions. First, should we be increasing the limit for FII investment in the GSec segment? The limits in the corporate debt and infra segments are underutilised as they do not evince much interest. Second, RBI has to take a call on the inclusion of this factor when formulating monetary policy once inflation moves down—which will hopefully happen by January or so. Third, RBI has to keep a close watch on the currency because the inflows of FII into debt from December was also associated with a relatively stable rupee. Last, just in case there are large outflows, how well are we prepared for it—RBI has managed this very well so far but will have to recreate a contingency plan for this extreme eventuality.
– Brutus, in Shakespeare’s Julius Caesar The unwinding of the US Fed’s QE has been as sensational as the invoking of the same. The Fed had begun this programme in late-2008 and the reason was simple: Low interest rates, on their own, could not restart the economy which had low liquidity as banks were reluctant to lend to one another. By buying back paper from the market, liquidity was induced. There were several misgivings on QE. But inflation remained subdued and did not rise, contrary to expectations. The impact on growth was not too clear, as the GDP did recover to grow by an average of 2.2% in the 4 years following negative growth of 0.3% and 2.8% in 2008 and 2009 respectively. However, one unintended consequence was the explosion in the flow of funds to emerging markets. It was a clear case of ‘carry trade’ where funds could be borrowed at a low cost and then invested in emerging markets which were de-coupled and booming. We all loved it. The shock came in May 2013 when the Fed hinted at unwinding the programme and the emerging markets took fright as funds did an about-turn and distorted the external accounts of countries like Brazil, India, Indonesia, Turkey, and South Africa. The actual tapering began from December when the $85 billion per month buyback of MBS and treasuries was sequentially reduced to $15 billion as of October 2014. Surprisingly, the markets fared better when the tapering actually commenced. Currencies have stabilised and it is back to business as usual. There is just another $15 billion of bonds to be bought up on a monthly basis, after which the Fed would have reached equilibrium. After this point, the economic indicators will decide the Fed’s course of action. The consensus is that near-zero Fed funds rate will continue for some more time and there would be an increase in rates in mid-2015 if inflation becomes an issue and growth stabilises. The unemployment rate too would be critical which in August was 6.1% and 5.9% in September. The removal of QE can be looked at from the point of view of USA and India. In the US, the bond yields movements have been idiosyncratic. Typically, lower QE and the prospect of higher interest rates at some point of time should put pressure on the bond yields. But the yields have responded in a varied manner. The 10-years yield increased from 2.53% in May 2013 to 3.03% in December 2013 and then came down to 2.52% in June and to 2.09% in October 2014, even going below the 2% mark during intraday trade. Clearly, the markets are not expecting the rates to increase any time soon. Also, the movement of funds into bonds has pushed up demand and prices and hence lowered yields. Movement of such funds is also a result of weakening of global commodity prices, especially of crude and gold, hence diverting investments. Crude oil has been down from a little over $100 in May 2013 to the early-80s in October 2014. With the dollar strengthening from 1.36-38 to the euro in June to 1.26-28 in the last month on account of the recovery in the USA—though IMF indicates that growth will be stable at 2.2% in 2014 too, as in 2013—funds are moving back to US treasuries. With fewer treasuries available as the Fed has stocks of about $4 trillion so far, the prices have increased. From now on the approach of the Fed will be important. Will it start raising interest rates? Will it start selling treasuries in the market to mop of funds and hence cure the price rise? The answers are not known and the inflation and employment numbers hold the clue. Till then volatility can be expected in the market. How about our own economy? How vulnerable are we? The Indian economy hit back quite well after the initial slip with action being taken by RBI to shore up forex reserves. The important variable to look at would be the FII investments in debt. This is more likely to be affected than equity as the latter is guided by a different set of factors as the character of investment is different for the two, though there can be substitution at the margin. The trends in such investment in debt are interesting. Following the tapering announcement in May, there were 5 months of net outflows of $13 billion till November 2013. Subsequently, when the tapering actually took place following the December 18 announcement, the FIIs turned buyers for the next 4 months to $6.6 billion. April 2014 witnessed an outflow of $1.5 billion, but after that for the next 5 months there have been continuous inflows of $15.4 billion. These numbers are heartening as the debt market has been attractive to the investors notwithstanding the tapering of the amount. The interest rate differential is important. With our GSec yields being high, at above 8%, and a stable exchange rate, the returns are attractive. This raises some questions. First, should we be increasing the limit for FII investment in the GSec segment? The limits in the corporate debt and infra segments are underutilised as they do not evince much interest. Second, RBI has to take a call on the inclusion of this factor when formulating monetary policy once inflation moves down—which will hopefully happen by January or so. Third, RBI has to keep a close watch on the currency because the inflows of FII into debt from December was also associated with a relatively stable rupee. Last, just in case there are large outflows, how well are we prepared for it—RBI has managed this very well so far but will have to recreate a contingency plan for this extreme eventuality.
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