Published on October 22, 2021 by Shiba Kumar Khuntia
All focus is on when the Fed will start tapering its bond-buying programme to position itself for interest rate hikes. Sooner rather than later seems to be the official stand given the improvement in the unemployment rate (4.8% in September 2021 versus 14.8% in April 2020) amid an increase in inflation (5.3% expected in September 2021 following 5.3% in August 2021 versus 1.3% in August 2020). The recent increase in inflation, which we think is transitory and driven by supply-chain constraints, has compelled the Fed to start thinking about tapering its existing USD120bn monthly bond-buying programme started in March 2020. This is understandable given the marginal utility of stimulus decreases as an economy comes out of recession. Typically, tapering would lead to a rise in bond yields globally while emerging economies witness capital outflows and currency depreciation. Furthermore, stock markets react negatively to tapering announcements, such as in 2013. However, we do not expect significant volatility in the market this time round given the improved reserve adequacy in emerging economies and gradual improvement in supply chains by 4Q, which should ease inflationary pressures.
At the July 2021 FOMC meeting, most committee members believed the time has come to reduce asset purchases, but they did not indicate a timeline. At the September 2021 meeting, the Fed chair proposed completing tapering by mid-2022, but again came shy of announcing a specific timeline. So, the question remains, how soon will the Fed announce tapering? We believe that whenever it does, it will be a gradual process aimed at positioning itself for interest rate hikes towards the end of 2022 or early 2023. The Fed likely wants to see further strength in the economy given that September 2021 non-farm payroll data (added 194,000 jobs) was below consensus (500,000 jobs), mainly due to the effects of the delta variant.
We believe the Fed will likely announce the tapering timeline at its November 2021 meeting, to normalise its balance sheet (USD8.5tn in assets as of September 2021 versus USD5tn in March 2020) and put a cap on the inflation rate amid a solid improvement in real GDP growth (c.6.5% YTD 2021 versus c.1.6% from 2013 to 2020), due to the pandemic’s base effect, improved corporate earnings and reducing unemployment. We think tapering may start in December 2021 or January 2022. USD15-20bn of tapering every month from January 2022 to June 2022 would translate into USD540-645bn of stimulus cumulatively from November 2021 to June 2022, almost equivalent to the QE2 stimulus programme announced in 2010.
Tapering to raise bond yields, pressure highly levered companies
Tapering has historically affected financial markets, with capital outflows and currency depreciation in emerging markets followed by rising bond yields. The Fed’s tapering announcement in 2013 led to a spike in the 10-year bond yield to c.3.0% by year-end from c.1.9% in January 2013. Hence, we think highly leveraged and capital-intensive companies would see an increase in their interest cost burden.
Tapering to impact emerging-market (EM) stocks, albeit moderately
Given near-zero interest rates, investors across the globe have borrowed in USD to invest in diverse assets. Now that the Fed is planning to start tapering, and this will likely be followed by interest rate hikes, investors would have to sell off their holdings, particularly in emerging markets, to pay off their USD-denominated loans. Such deleveraging typically leads to markets tumbling. After the Fed’s tapering announcement in 2013, the MSCI EM Index underperformed at -2.6% versus +26.7% for the MSCI World Index.
That said, we believe markets will not behave the way they did in 2013, primarily because a lot has changed since then as the reserve adequacy of emerging markets has improved. The Federal Reserve Bank of Dallas states a reserve adequacy of 7% indicates a country has a sufficient precautionary buffer of reserves to meet its potential FX liquidity needs in an adverse situation. In 2013, only 5 of the 13 major emerging markets had reserve adequacy more than 7%; the number had improved to 11 countries as of 4Q20. This would make them less vulnerable to Fed tapering this time. We also believe that as the Fed hikes interest rates, other central banks would follow, to attract investors, offsetting capital outflows to an extent. The recent market response substantiates our argument; inventors did not take this tapering information too negatively given that the Fed had informed markets well in advance, unlike in 2013. However, the caveats to our arguments would be a deterioration in economic growth, persistent supply chain pressure, weak job data and inflation.
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US unemployment rate, 5 October 2021, US Bureau of Labor Statistics
Payroll employment rose by 235,000 in August 2021, Bureau of Labor Statistics
J. Scott Davis, August 2021, Federal Reserve Bank of Dallas, “Don’t Look to the 2013 Tantrum for the Effect of Tapering on Emerging Markets”
U.S. Bureau of Economic Analysis, “Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP by Industry, Second Quarter 2021”
Fed Total Assets, 2021, Board of Governors of the Federal Reserve System (US)
MSCI EM and MSCI World Index performance, September 2021
10 Year Treasury Rate, 2021, Macrotrends
US inflation rate, 14 September 2021, Bureau of Labor Statistics
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About the Author
Shiba Kumar Khuntia is part of the Investment Research team at Acuity Knowledge Partners. He has spent more than five years in his current role covering the U.S. Industrial Machinery at Acuity Knowledge Partners and currently supports sell-side clients with research assignments including industry research, economic research, thematic reports, and earnings reviews. He holds an MBA in Finance from Rizvi Institute of Management, Mumbai.
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