Tuesday August 10, 2021

Beware the Federal Reserve

Author: Adit Jain, Editorial Director, IMA India June 2021

The Federal Reserve – our problem

Earlier this month, we ran the Q2 FY22 round of our quarterly Business Confidence and Performance Index (BCPI) survey. Having dipped from a high of 73 in January to 60.6 in April, the index has now climbed back up to 66.6. Values above 50 imply net optimism/expansion, and those below 50 the opposite.

At a G-10 meeting in Rome in 1971, John Connolly, the then US Treasury Secretary, told his astonished counterparts “The dollar is our currency, but it is your problem”. This comment drove what effectively was the final nail into the coffin of the Bretton Woods system of monetary management. Mr Connolly, a straight-talking Texan, was not known for tact. As it happens, his comments remain accurate to this day. More recently, in 2013, after the Global Financial Crisis began to settle, Ben Bernanke, the Chairman of the Federal Reserve, in a press briefing mentioned that America would start scaling down the monthly purchases of bonds. Consequently, the markets panicked as investors began to dump US Treasuries and what followed became known as the ‘Taper Tantrum’.

The Dow crashed by over 100 points; bond yields spiked upwards and their prices fell; the overall cost of borrowing jumped and there was a flight of capital out of emerging markets, creating a liquidity nightmare as investors scurried to the safety of the dollar. Global currencies tumbled and those of Turkey and India were pounded to all-time lows. In a matter of three months the Rupee lost a quarter of its value. The actions of the US Fed usually have a more profound impact on global markets and various economies than those of their individual central banks. Some analysts fear that we might, in the coming year, see a repeat of the events of 2013.

Governments and their agencies buy bonds to inject liquidity. Amongst these, treasuries are the most secure because sovereigns back them with full faith and credit. Bond prices, like those of equity, are volatile and when bond prices fall their yields go up; vice versa, when bond prices rise. A movement in 10-year treasury yields say from 2.2% to 2.6% indicates negative market conditions. Central banks, like the Reserve Bank of India and US Fed, can influence the economy by setting short term interest rates. When the economy slows, they reduce rates and when it heats up, they increase them. A problem happens when interest rates are near zero and there is no scope to reduce them further. It was in response to this that the Fed devised a new weapon that came to be called ‘quantitative easing’. The way this works is that the Fed prints money and then buys bonds or other financial assets from banks. Consequently, banks are flushed with liquidity and the cash available to them can then be loaned to others. This creates a rise in lending and makes it easier to finance projects, thereby boosting economic growth. The Fed’s purchase of bonds also results in an increase in their price by reducing supply. This causes their yields to fall, with an accompanying reduction in funding costs.

In the aftermath of the global financial crisis in 2008, the Fed purchased bonds amounting to USD 4.5 trillion. Post covid, it soaked up an additional USD 4.1 trillion taking the total to a whopping USD 8.5 trillion. Other major central banks, too, made bond purchases. For instance, the Bank of England clocked USD 1 trillion and the European Central bank, USD 2 trillion. Consequently, the expansion in central bank balance-sheets added up to about USD 11.5 trillion.

Whilst it’s true that the purchase of bonds helped power the global economy, this also came with a flip side. First, one could argue that this actually helped banks much more than the economy since they could (and often did) opt to strengthen their own balance sheets by keeping the money, rather than give it out on loan. Second, creating new money made the US dollar less competitive against foreign currencies; third, increasing the money supply by these large proportions raised the risk of inflation. Finally, lots of money chasing few assets resulted in price bubbles not only in America but across the world. Stock markets in many countries have been particularly impacted, with a palpable mismatch between mid-term profitability of corporations and their current valuations. What happens is that cheap money finds its way into emerging markets, through investment funds and often in equities and real-estate, creating bubbles in various asset classes. This flow of money out of markets, where it is created cheaply, for instance in America, Europe or Japan, is called the ‘carry trade’. This has played a role in the current stock prices in India.

Inflation in America jumped abruptly to 5.5% in June 2021 creating headaches for both financial markets and the Fed. Until this happened, almost everyone had smugly assumed that inflation, stuck at levels below 2%, was not going to be a worry anytime soon. Initially, the Fed responded by suggesting that this was temporary in nature and prices would stabilise quickly. But the fact is that the Fed is now anxious about inflation and may consequently be forced to bring forward the tapering and eventual end of its bond purchases. Jerome Powell, the Fed’s Head, in a hint to the markets announced that the ‘Fed was talking about talking about a rise in interest rates.’ With America’s economy showing signs of heating up – GDP growth in 2021 is likely to be a whopping 7% – Mr Powell may have to start talking sooner than he might have liked. Analysts are now justifiably worried that a tapering in bond purchases may begin around the first half of next year and a lot quicker than formerly predicted. This would create a turmoil in financial markets, affecting both bond prices and equities. Asset bubbles elsewhere, for instance in unlisted convenient valuations, too may fall.

So, what should we expect? First, we suspect that the tapering of bond purchases will begin in H1 2022 leading to a rise in interest rates perhaps by 2022 end or 2023 H1. This would almost certainly result in money hurriedly leaving emerging markets including India. Consequently, liquidity would be squeezed and prices of equities and bonds would correct. However, the correction may not be as drastic as some might have predicted, largely because systematic investment plans, driven by mutual funds, has channelled large resources into financial markets. Basically, the saving habits of Indians have witnessed a shift, where middle class families direct their savings towards equities and bonds, rather than traditional asset classes like gold and real-estate. The second impact would be on currency markets where the Rupee would fall in value against the greenback, as foreign investors skitter back to the safety of the US dollar. The opportunity of higher returns in America, as bond yields rise, will attract capital from off-shore higher risk exposures. The third impact will be on inflation in India, which would rise because of a weaker currency. It is likely that start-up funding would be impacted as cheap money has been a major driver to higher risk investments. As money becomes expensive, investors will become more cautious.

There is likely to be some sort of correction in asset prices, specifically in real estate and equities. The Reserve Bank of India will face a dilemma – it will want to increase liquidity and reduce interest rates but may be unable to do so as inflation pressures rise. It may, in fact, have to harden interest rates to keep inflation in check but also to provide better returns to investors to prevent a foreign exchange exodus. Be that as it may, many economists expect that this time around, normality will return much quicker, largely because the Fed has been providing excellent guidance over the past few years and financial markets are unlikely to go in for a shock. Volatility is mostly created by the unexpected when markets are surprised. If proper guidance is issued, they should behave more responsibly. The ten-year Treasury yields should rise to about 1.6-1.7% by the end of the year and the dollar will hold around 110-yen mark.

Companies should consider raising funds and locking them in on preferable rates now, rather than leave this for later when markets become volatile. The cost of funding in 2022 and beyond, we expect, will be a few notches higher and liquidity scarcer. In business, as in life, timing is everything. This is a good time for stocking up on money. A year later may be different.