When the economy is under pressure, it is indicative of a liquidity crisis. In such situations, governments and the central banks use the most viable option to avert an economic crisis- buying pre-ordered government bonds and other assets to fill the economy with liquidity. This process is called quantitative easing (QE), and quantitative easing plays a vital role in the topic at hand here, i.e., Taper Tantrum in the stock market.
Recently, with the spread of the COVID-19 pandemic, economic hardship and destruction ensued in every economy worldwide. To tackle the monetary crisis, most central banks, including the Reserve Bank of India, took steps involving quantitative easing to revive the economy by lowering interest rates and sending monetary benefits to citizens.
In this light, the concept of tapering is linked to a central bank’s banking strategy involving the gradual completion of the quantitative easing process.
Tapering happens when the government stops injecting money into the economy and the banks by reducing its bond purchase to make the economy independent of the extra support gradually.
Quantitative Easing (QE) effect and interest rates
Quantitative easing lowers interest rates. This reduces the returns (ROI) for investors on safe investments, such as certificates of deposit (CDs), money market loans, corporate bonds, etc. Therefore, investors are forced to invest with reasonable risk to generate significant returns. As an alternative, many of these investors consider building their stock market investment portfolios which heavily alter stock prices and increase volatility.
Falling interest rates also influence the decisions of listed companies. Lower interest rates mean lower borrowing costs. This encourages companies to grow their business and borrow more often.
Tapering is the decrease of the rate at which a central bank purchases new assets. It is a gradual reduction in the flow of significant acquisitions of goods and securities by a central bank. Once the tapering is complete, a central bank may reduce the balance sheet size. The goal is to remove financial rewards and incentives slowly.
Tapering is not a new phenomenon. However, the first time it occurred in a way that had a significant global impact was during the 2013 Taper Tantrum. The “tantrum” resulted from the overestimated fears of stock market participants after the US government announced aid cuts.
The 2013 Taper Tantrum
The 2008 financial crunch led to a prolonged recession. As a result, the stock market experienced an unprecedented atmosphere of panic selling shares and other securities. Using the quantitative easing strategy, the US federal government immediately took steps to purchase large government bonds to maintain some form of liquidity in the economy.
This assisted in keeping the lending charges low and increased liquidity in the economy, assuring the investors of a better future.
Low-interest rates encouraged many people to increase credit and spending and accelerated the growth of businesses. From 2008 to 2015, the US government’s investment in the economy was approximately $4.5 trillion, up from $870 billion until 2007.
It’s important to remember that government-led investing in the economy is a short-term solution to a financial crunch. A long-term liquidity infusion by the government can lead to a high inflation rate in an economy.
When the US economy started to improve, the federal government announced a plan to lower the quantitative easing program by 2013. The US market weakened and fell by 4%, fuelling an international stock market downturn. The ‘digitally super-charged’ investors blew it up worldwide, and international markets reacted negatively to an event they should have already been expecting.
Indian stock market
Due to low interest rates on loans during the QE phase in the US, borrowers were in an accessible position when the lending position was stressed. Even though there was more money to be borrowed, lower interest rates hurt lenders. The financial sector needed more consistency. Around this time, American investors began parking funds in Asian markets, including the emerging Indian market—this boosted foreign investment and FDI in India.
As the US government implemented tapering, US interest rates rose, and investors started returning home to get better returns on their investments. In doing so, they pulled out funds from the Indian ecosystem.
Following this rebound, the Indian Rupee fell significantly along with foreign investment returns. This pushed the Reserve Bank of India to raise interest rates overnight. The dollar continued to strengthen, leading to inflation in India. This put investors in a frenzy of crisis and disrupted the growing economy.
India and other emerging markets were hit hard by inflationary pressures. The pain increased as the currency depreciated against the US dollar. After tapering, investors expected a catastrophe on the stock markets. But the impact was cushioned and thankfully short-lived.
Impact of tapering on markets
As mentioned above, tapering often leads to ‘taper tantrums’, i.e., the common panic that accompanies the central bank decreasing its QE program. As central banks start to buy fewer assets, fears that liquidity would decline, and the global market could crumble generates fear waves among investors.
A taper tantrum often pans across bond prices. And when bond prices decline, bond yields grow. There is always a probability that shares and indices could accompany the trend since the bond market boosts stocks. However, in previous tapering scenarios, this has never actually occurred.
During the US tapering, interest rates and bond yields rose. The US stock market performed fine, while the impact on Indian markets was minor. Between 2013 and January 2020, before the onset of the COVID-19 pandemic, Sensex rose by a massive 105%.
COVID induced impacts on stock markets and investors
Due to the COVID-19 pandemic and its associated risks, the US Federal Government began acquiring government assets and bonds again in 2020. The Federal Government bought securities worth $120 billion from the market. But as the situation improves, tapering by slashing the bond-buying programme is inevitable.
Since investment into India ever since the US restarted its bond-buying programme has not been notable, India may not have much to lose if a situation of investor outgo arises. Despite the announcement, the Indian markets cushioned volatility and fell by 1%, keeping its record-high performance.
As the news of a fresh round of tapering is breaking, many are curious about its impact on the Indian market. It is given even more importance due to the possibility of a third COVID wave.
The fact for the Indian market and economic conditions remains that the economy’s fundamentals are much better than what they were during the global fiscal crisis. So, experts anticipate that while there may be some short-term impact, the tapering process will not affect the Indian economy that much.
The impact on Indian equities may be negligent, as seen during the first taper. Internal institutional investors such as mutual, insurance and pension funds can step up the buying to reduce the impact. With the retail investors’ population increasing in India, prominent foreign portfolio investor (FPI) outflows may not adversely affect the market much.
Nonetheless, the stock market is unpredictable, and it is reasonable that investors remain careful of their positions on the stock market.