On a tight note, the US Federal Reserve stuck to its plan. It started the program at the beginning of January and ended it quickly by lowering new bond purchases to zero at the end of March 2022. Now interest rate hikes are continuing and the balance sheet is shrinking. With the monetary stance regarding the decline in the balance sheet, which is expected to begin in July-August, it is not out of the question to look into what happened in the previous stimulus round to see what lies ahead.
Looking back, in the first stimulus cycle of the Fed (after the global financial crisis), although the decline began in 2013, it was not until late 2017 that the Fed really began to take serious steps to reduce its balance sheet. For those who are not initiated, a taper refers to reducing the size of new bond purchases, while a reduction in the balance sheet refers to allowing previously purchased bonds to mature without repurchasing. As is well known, the latter has a much greater impact on the market, as the excess liquidity position is extracted by allowing the bonds to mature without repurchases. Thus, the Fed reduces the size of its balance sheet after each cycle of harassment.
This time, the central bank also has an ambitious plan to reduce its pandemic by planning to reduce its balance sheet by a significant measure in the coming months. According to some estimates, it could, in all likelihood, start at $ 25 billion a month from July-August and slowly rise to $ 95 billion to complete all demolition by December 2023.
If that happens then we’re talking about taking over $ 1.7 trillion in liquidity out of the system in 18-19 months. To put it in context, it will be almost three times the $ 660 billion that was withdrawn in the first round of 2018-19.
By any standards, this is a huge relaxation. The world had never witnessed such a great deal of liquidation at any time in the past. Of course, given what was pumped into the pandemic (close to $ 5 trillion), the scale of relaxation might not seem significant. Given that the central bank’s balance sheet grew from $ 4 trillion to close to $ 9 trillion during the pandemic, a gradual decline over the long term is probably the best result that can be expected. However, markets are naturally concerned about whether FIIs will ever return to emerging markets this season. Given these foreseeable liquidity challenges for the foreseeable future, it may seem realistic to assume that the FIIs are unlikely to return any time soon, especially after their massive exodus from India in October 2021. For information, they have withdrawn over $ 23 billion (net sales) since then.
It’s right here, where a peek into the previous liquidity round could provide an interesting insight into how FIIs behaved in similar situations. Let’s go back and look at the period between January 2018 and August 2019. During this period, the central bank reduced its balance sheet by more than 660 billion dollars by withdrawing an average of 30 billion dollars each month (the exact amount varied from the lowest 16 dollars ). billion up to $ 61 billion in different months).
It further helps to divide this period in two to understand how the behavior of FIIs changed during the time of relaxation. Initially, as the central bank began to unwind, FIIs began to pull out in February 2018 and accelerate their mid-year pace to peak sometime in October-November 2018. They withdrew over $ 6.5 billion on this period. But what happened was a post that was more interesting. Up to this time, the Fed’s relaxation was about $ 30 billion a month, which later increased to $ 38 billion a month from January to August 2019. It is ironic that after increasing the amount of monthly relaxation from the Fed, the FII flow turned into inflows and it became huge . net inflows over $ 13 billion during that period. It should not be forgotten that during this period, more than $ 300 billion was withdrawn by the Fed to reduce its balance sheet.
So what do you conclude from this? Is there a correlation between the Fed’s downturn and the FII’s flow? Of course, there is interconnection in the initial period, but not long after. More importantly, what is more interesting is that the inflow in the second part was double the outflow in the beginning. Having said that, it is also important to keep in mind that no two cycles will be the same. Although the broad pattern may be similar, it may be difficult to predict the exact location where the tide will change for FII flow. But what’s more important to understand is that FII money will come back much sooner than the Fed’s timeline to unwind. Not only will it be sooner, but it will be much bigger than what went out. This is one of the reasons why some experienced investors expect meltdown (bull run) in Indian markets next year (2023).
From this point of view, the current weakness, which is likely to continue for several months due to the central bank’s rise in interest rates and the declining balance sheet, is a great opportunity for long-term investors to take their position, especially on these irregular days.
(ArunaGiri N, is the founder, CEO and fund manager at TrustLine Holdings.)
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