US Fed finally starts tapering its liquidity program

Remember, taper is just a reduction of liquidity and not a rate hike. However, it logically implies that a rate hike may not be too far; with the US inflation persisting above 5%.

Nov 04, 2021 05:11 IST India Infoline News Service

The much-awaited US Fed statement had a crisp message. The Fed was not waiting any longer for tapering. It will start monthly taper of $10 billion in treasuries and $5 billion in MBS from late November. From Nov-21 the monthly taper will stand reduced from $120 billion to $105 billion, consisting of $70 billion in treasuries and $35 billion in MBS (mortgage backed securities).

As the Fed tapered the liquidity taps, the US bond yields spiked above 1.60% while Indian yields edged closer to 6.40%. Remember, taper is just a reduction of liquidity and not a rate hike. However, it logically implies that a rate hike may not be too far; with the US inflation persisting above 5%.

Hawkish signals from the CME Fedwatch

One way to assess the probability of a rate hike and its timing is to look at the CME Fedwatch. This is the implied probability of different Fed rate scenarios over the next 10 Fed meetings. The table below captures the gist of these probabilities.

Fed Meet 0-25 25-50 50-75 75-100 100-125 125-150 150-175 175-200
Dec-21 100.0% Nil Nil Nil Nil Nil Nil Nil
Jan-22 97.5% 2.5% Nil Nil Nil Nil Nil Nil
Mar-22 84.3% 15.4% 0.3% Nil Nil Nil Nil Nil
May-22 72.2% 25.3% 2.5% Nil Nil Nil Nil Nil
Jun-22 36.6% 48.4% 13.7% 1.3% Nil Nil Nil Nil
Jul-22 27.7% 44.9% 22.6% 4.5% 0.3% Nil Nil Nil
Sep-22 15.2% 37.1% 32.6% 12.7% 2.2% 0.2% Nil Nil
Nov-22 11.4% 31.7% 33.7% 17.6% 4.8% 0.7% Nil Nil
Dec-22 4.6% 19.6% 32.5% 27.2% 12.4% 3.1% 0.4% Nil
Feb-23 3.6% 16.3% 29.7% 28.4% 15.7% 5.2% 1.0% 0.1%

Data source: CME Fedwatch

Normally, a probability of 25% and above, hints at strong likelihood. Here are 4 inferences.

a) With the Fed aggressive on taper, the first rate hike to the range of 25-50 bps could happen as early as May-22.

b) Post Jun-22, the probability of the second rate hike to 50-75 bps gathers momentum and the second rate hike could follow as early as Jul-22.

c) By December 2022, the markets are expecting a high probability of the third rate hike to the range of 75-100 bps.

d) The data indicates uncertainty about the fourth rate hike, but if inflation does not come under control, then fourth rate hike to 100-125 bps could happen by Feb-23.

In a nutshell, the CME Fedwatch indicates that, with the taper starting right away, the rate hikes could get front-ended to May 2022.

Here is what the Fed announced

The Fed ended the suspense over the taper and announced the start of tapering. Currently, Fed is buying $80 billion of treasuries and $40 billion of MBS each month. Here is what the Fed statement said.

• Fed remains committed to use all tools at its disposal to ensure that the growth revival is sustainable and broad-based. The target is to keep the overall policy accommodative till the target of full employment is reached. However, Fed has no answer to the inflation riddle; caused by supply side factors.

• The FOMC opted to keep the Fed rates static in the range of 0-25 bps. However, by end of November, Fed will reduce asset purchases by $10 billion of treasuries to $70 billion a month. It will also reduce MBS by $5 billion to $35 billion a month.

• Effective December 2021, Fed will taper the asset purchases of treasuries to $60 billion and MBS to $30 billion. Unless there are some economic pressure points, the entire asset purchase program post-COVID would be fully stopped by mid-2022.

• The Fed believes that substantial additional progress had been achieved on economic recovery, jobs and balanced growth; even as inflation was much higher than the comfort level of the Fed. This had forced an early taper.

In short, the taper has started and the liquidity engines are likely to be tightened.

What does this Fed taper mean for Indian markets?

Towards the end of October 2021, FPI selling in India was ostensibly driven by valuation concerns. However, valuation concerns were always there and the actual trigger was the US Fed taper. Indian markets have been one of the beneficiaries of the liquidity largesse into emerging markets in search of higher risk-adjusted returns. These passive country-specific flows are likely to gradually slow down.

The second major implication for the Indian market will be on the IPO front. In the midst of the glut of global liquidity, mega digital IPOs like Zomato, Nykaa and Policybazaar enjoyed heavy oversubscription. This level of liquidity flows could taper.

The third implication is that the RBI is unlikely to risk monetary divergence. Last week, the variable rate repos (VRR) announced by RBI was the first signal that it would not hesitate to suck out liquidity, if warranted.

Last, but not the least, this will be a much needed return to reality. The liquidity infusion was just a temporary measure to give confidence to markets, not a permanent feature. Indian economy and markets will have to learn to adjust to non-pandemic levels of liquidity.

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