The US Federal Reserve has started to undo its expansive monetary policy and the markets have started to roll on the floor from the taper tantrum 2.0. The riskiest assets where most of the hot money had been deposited in the last two years are witnessing big crashes.
The Nasdaq Composite Index is down more than 9 percent since last week’s Fed meeting in which the fed funds rate was raised 50 basis points; for the second time this year. It has also announced a monthly reduction in outstanding bonds starting in June.
Bitcoin and other cryptocurrencies are witnessing a virtual stampede out the door with prices falling more than 15 percent in the last week. 10-year US sovereign bond yields crossed 3 percent, the dollar index soared and there was a run on emerging market currencies and bonds.
We can’t really blame the markets for trying to twist the Fed’s arm, as the taper tantrum 1.0 in 2019 had been quite effective.
The sell-off in the stock and bond market in the last quarter of 2019 caused the Fed to halt its rate hike and balance sheet shrinkage, even though the economy was on solid footing.
Will the Fed stay the course this time, as opposed to 2019? It is very likely that this time the Fed will not be moved by the antics of the markets. One, US President Joe Biden is unlikely to be angry about the stock market crash and influence the Federal Reserve to back down, as Donald Trump did. Two, the US debt accumulation has grown too large for the Fed to take it easy.
No Trump Effect
Donald Trump was a big fan of the market ticker and believed that the bull run in the Dow Jones during his tenure was a testament to the effectiveness of his Presidency. He also believed that interest rates should be lowered and not raised to help the stock markets. He put enormous pressure on the Federal Reserve in 2018 and 2019 through scathing tweets to reverse monetary tightening.
According to an analysis by Yahoo Finance, he tweeted about the Federal Reserve 100 times since Jerome Powell’s appointment as chairman and these tweets increased in the days leading up to the policy meeting.
“The only problem our economy has is the Federal Reserve. They have no idea of the market…” read a tweet in December 2018.
“It would be great if the Fed lowered interest rates and quantitative easing even more. The dollar is very strong against other currencies and there is almost no inflation. This is the moment to do it. Exports would increase”, wrote one of his other tweets in December 2019.
Jerome Powell is surely a happier man now, as he can get on with his task without a belligerent POTUS breathing down his neck. Much to Powell’s relief, Joe Biden has shown little interest in stocks or other markets thus far.
The other reason the Fed is unlikely to back down is because of the sheer amount of debt it has accumulated since 2008.
the growing debt
The Fed’s liabilities stood at $869 billion in August 2008. As the central bank began printing money beginning in the last quarter of 2008, liabilities grew steadily to $4.427 billion at the end of December 2015. .
While the addition of new liabilities ceased in 2015, the Fed was able to reduce outstanding liabilities only much later, between October 2017 and September 2019. But then the balance sheet contraction stopped and a new stimulus program began in 2019. , at Trump’s urging, “to save choppy markets.”
Due to Powell’s failure to tighten under Trump, Fed liabilities totaled $4.12 trillion in February 2020. Pandemic-related stimulus has added another $4.778 trillion with total liabilities now standing at $8.898 trillion. millions.
This level of debt is clearly unsustainable. Fed liabilities as a percentage of US GDP were 6% prior to 2008. It increased to 19.2% in February 2020 and stood at 37.5% in April 2022. Research has shown whereas the consequences of high public debt are high inflation and slower growth; these are already manifesting in the US economy. If these persist, the country could be heading towards stagflation.
High government borrowing also crowds out private investment, affects the economy’s long-term output, and could lead to unfavorable fiscal measures to finance the debt burden.
Taper Lessons 1.0
So Fed Chairman Jerome Powell is in a hurry to reduce this debt load. He, too, appears to have learned from mistakes made on the 2015-19 downsizing schedule. The Fed had waited too long, almost seven years, after the GFC to start cutting stimulus. It had also proceeded extremely slowly and cautiously, making a 25bp hike in December 2015, the next 25bp hike in December 2016 followed by seven more hikes through the end of 2018, after which it stopped raising rates.
The balance sheet contraction was also extremely slow, with only $10 billion in securities being withdrawn each month since October 2017, only to gradually increase to $50 billion per month in October 2018.
However, the Fed seems determined to accelerate rate hikes as well as balance sheet shrinkage this time (see chart). About $95 billion of Treasury and mortgage-backed securities will be withdrawn every month beginning in September. But even at this level, it will be 2026 when Fed liabilities reach pre-pandemic levels. Interest rate hikes are also being anticipated so that another adverse event does not stop policy normalization. Median projections from FOMC members point to another 90bp hike in 2022 and 100bp hike in 2023.
Can the markets bear this?
With the normalization of monetary policy expected to continue for many years, market participants will eventually have to adjust to an era of less liquidity and accept that it is okay for asset prices to decline to fair value.
India will be affected by the rising cost of borrowing abroad for Indian companies and government. Foreign portfolio flows may continue for some time to come from Indian stocks and bonds, also putting pressure on the rupee. But once global markets settle into the new norm of lower liquidity and higher rates, Indian markets will follow too.
May 11, 2022