Taper is behind, but tightening is ahead. That is a subtle one-liner that captures what to expect from the US Federal Reserve going forward.
On taper, the US Fed stuck to its schedule. It began the program in early January and quickly finished it by winding down new bond purchases to zero by end of March 2022. Now, it is moving on to rate hikes and the balance sheet shrinking. With monetary tightening in terms of balance-sheet reduction expected to begin by July-August, it will not be out of place to peep into what happened in the previous stimulus cycle to get a sense of what lies ahead.
Looking back, in the earlier Fed stimulus cycle (post-Global Financial Crisis), though the taper started in 2013, it wasn’t until late 2017 that the Fed really started taking serious steps to shrink its balance sheet. For the uninitiated, taper refers to winding down the size of the fresh bond purchases while balance sheet reduction refers to allowing those earlier purchased bonds to mature without repurchases. As is well known, the latter has a much bigger impact on the market as the excess stimulus liquidity is pulled out by allowing the bonds to mature without repurchases. That’s how Fed scales down its balance sheet size after every stimulus cycle.
This time, too, the Fed has an ambitious plan to arm down its pandemic stimulus by planning to shrink its balance sheet by a sizable scale in the coming months. As per some estimates, it may, in all likelihood, start with $25billion dollars a month from July-August, and slowly accelerate to $95 billion to end the entire unwinding by December 2023.
If that happens, one is talking about taking out over $1.7 trillion of liquidity out of the system in 18-19 months. To put that in perspective, it will be nearly thrice of $660 billion that was pulled out in the previous cycle in 2018-19.
By any scale, this is a massive unwinding. The world had not witnessed such a large-scale winding-down at any time in the past. Of course, relative to what was pumped during the pandemic (near $5 trillion), the scale of unwinding may not seem sensational. Given that the Fed’s balance sheet expanded from $4 trillion to near $9 trillion during the pandemic, a gradual reduction over the extended period is probably the best outcome one could hope for. Yet, markets are naturally worried about whether FIIs will ever return to emerging markets in this period. Given this huge overhang of liquidity challenges for the foreseeable time, it may seem realistic to assume that FIIs are unlikely to return any time soon, especially after their massive exodus from India in October 2021. For the record, they have pulled out over $23 billion (net sales) since then.
It is precisely here, where a peep into the past liquidity cycle could throw some interesting insights into how FIIs behaved in a similar situation. Let us go back and look at the period between January 2018 and August 2019. In this period, the Fed reduced its balance sheet by over $660 billion by pulling out an average of $30 billion every month (the exact amount varied from a low of $16 billion to as high as $61 billion in different months).
It helps further to split this period into two to understand how FIIs’ behaviour changed over the time of the unwinding. In the initial part, as the Fed unwinding started, FIIs started pulling out in February 2018 and accelerated their pace during the mid-year to reach the peak sometime in October-November 2018. They pulled out over $6.5 billion in this period. But, what happened post that was more interesting. Until this period, Fed’s unwinding was about $30 billion per month, which later increased to $38 billion per month from January till August 2019. Ironically, after the increased quantum of monthly unwinding from the Fed, FII flows reversed into inflows and there was a massive net inflow of over $13 billion in that period. Not to forget that in this period, over $300 billion was pulled out by Fed to reduce its balance sheet.
So, what does one conclude from this? Is there a co-relation between Fed’s unwinding and FII flows? Of course, there is co-relation in the initial period, but not long after. More importantly, what is more interesting is that the inflows in the latter part were twice the outflows in the initial part. Having said this, it is also important to keep in mind that no two cycles will be the same. While the broad pattern may be similar, the exact point at which the tide will change for FII flows could be difficult to predict. But what is more important to understand is that the FII money will come back much sooner than Fed’s timeline for unwinding. Not only it will be sooner, but it will be much larger than what went out. This is one reason why some seasoned investors are expecting a melt-up (bull-run) for Indian markets next year (2023).
From this perspective, the current weakness, which is likely to continue for a few months on account of the Fed’s rate-hike and balance-sheet-shrinking overhang, is a great opportunity for long-term investors to lap up their positions, especially on those sporadic panic days which will come often for a while.
(ArunaGiri N, is founder, CEO & fund manager at TrustLine Holdings.)