Has the stage been set for Taper Tantrum 2.0?

Updated: Mar 25



 

COVID-19 was (hopefully) a once in a lifetime event that required significant government support to respective economies worldwide. The US Federal Reserve responded to the onset of the pandemic by implementing Quantitative Easing, a term made famous during the period of 2009-14. So, what is Quantitative Easing (QE)? Investopedia defines QE as a form of monetary policy used by central banks as a method of quickly increasing the domestic money supply and spurring economic activity. It is essentially a way of increasing the liquidity in the market by purchasing government bonds and other securities, mostly from leading banks in the country. The result is increased cash availability with banks and hence a reduction in lending interest rates, thereby making it more attractive for businesses to borrow and grow, and for consumers to purchase products.


Japan was one of the earliest proponents of QE, having implemented it in the aftermath of the Asian Financial Crisis of 1997. While the QE program implemented by Japan was unable to achieve its desired objective, it established a blueprint for a tool to fight an economic recession. Post the global financial crisis in 2008, the US Fed injected trillions of dollars over a 5-year period (2009-14) to help rescue the US economy. Come March 2020, and it was Déjà vu for the US Fed with COVID-19 causing global havoc and debilitating economies worldwide. And so, QE was implemented once again. Between March 2020 and September 2021, US Fed’s balance sheet has expanded by more than 100% from USD 4.2 trillion to USD 8.5 trillion!


So, what’s the problem?


On paper, it seems like QE is a smart approach. After all, when an individual, let’s call him Rahul (naam to suna hoga!) fractures a leg, doesn’t the doctor put a cast and give him a crutch till the leg is strong enough to support the weight of the body on its own? QE does just that right? Let’s go back to our analogy. The doctor gave Rahul a crutch so that he could walk around, do the household chores, essentially stay productive. What if Rahul on the other hand decides to not hop around with the crutch and instead sets himself down on the sofa and uses the crutch only to play table hockey? Purpose defeated? QE as that issue too. Data shows that QE has a positive correlation with a bull run rally on the bourses. The excess liquidity created doesn’t all go towards productive investment or consumer spending. A lot of it makes its way to stock trading.


Not ideal. But still, at least everyone’s making money in the stock market. So, why worry?


Rahul’s leg is healing. The doctor takes away the crutch. Anjali is done being the patient wife (oh yes, they got married) and so Rahul needs to wash the utensils. Suddenly there’s no crutch or time for table hockey. The US Fed does that too, through a process called tapering. US Fed started to lower its purchase of securities in November 2021 and doubled the pace in December 2021. Interest rate hikes are expected to be implemented not too much later (expected before mid 2022, unless Omicron decides to delay the plan) with the inflation running red hot and that’s when the party stops. Increasing interest rates would lure large foreign institutional investors to pull out money from emerging economies and invest in safer avenues i.e., developed countries. A behavioral pattern known as ‘taper tantrum’.


Is this just a theory or is there a precedent?


Taper tantrum was most recently witnessed in 2013. Between 2009 and 2013, foreign institutional investors had borrowed at low interest rates in the US and invested in higher return securities in India. In May 2013, in response to the Fed’s announcement of cutting back on purchase of securities, investors reacted immediately by re-directing money from emerging markets. Foreign institutional investors withdrew money from India leading to a significant depreciation of the Indian rupee and a fall in stock prices. We are seeing Indian rupee depreciating below 76 level.


Does that mean taper tantrum 2.0 is likely to happen too?


Now that’s a tricky one to answer. Simple rationale suggests that foreign institutional investors withdrawing money is inevitable once interest rates begin to rise in the US. However, there are arguments against a drastic and sudden fall in Indian stock prices. For one, India’s foreign capital reserves are lot healthier now than in 2013 (USD 630 billion now compared with USD 270 billion in 2013) which means that the RBI has more ammunition at its disposal to counter capital outflow to avoid a run on the Indian rupee. Secondly, unlike 2013, the Fed this time is expected to run a smoother transition from asset purchases to balance sheet downsizing. The counter is that the current valuation of stocks is not substantiated by the performance of the underlying business and hence a correction (fall or time correction) even if gradual is only logical. Also, in the event the RBI is unable to ward off currency depreciation, the consequence could be additional capital outflow due to diminishing dollar returns for investors. Interest rates would then have to be hiked by RBI to improve investment returns in India as an incentive to reduce capital outflow but that would slow down the economic recovery and business performance and hence raise further question marks on stock valuations.


Hmmm. What’s SocInvest’s approach to this unpredictability?


We believe in fundamentals. Look for businesses that have strong foundations, good performance record, a credible management team and current valuation below fair value (with margin of safety). We like to invest periodically to average out our investment value and then hold for the long term to allow the business to achieve its potential. Investing in a stock is not too different from a raising a child and their respective tantrums. In both cases, you nurture with time and effort and wait patiently for them to mature into your most valuable endeavors.


 

About the Author


I have over 14 years of experience in investment banking and wealth management. I am an engineer by background and MBA from a premier institute in India.

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