Aggressive Fed tightening could throw a spanner in D-Street party

Minutes of meeting showed Fed plans to shrink its $9-trn balance sheet by over $1 trn a year, pare bond holdings by $95 bn a month to cool off inflation which has hit four-decade high

The Federal Open Market Committee (FOMC) minutes released Wednesday night indicate a more aggressive monetary tightening by the US central bank. The minutes of the meeting showed that the Fed plans to shrink its $9-trillion balance sheet by more than $1 trillion a year. It plans to reduce its massive bond holdings by as much as $95 billion a month to cool off inflation which has reached its highest level in four decades. The 10-year US Treasury yields have already hardened in the past one month from 1.77 per cent on March 7 to 2.6 per cent. In the past rising bond yields in the US have triggered huge drawdowns in the domestic market.

The benchmark indices have come off more than 2.5 per cent in the previous three trading sessions but are still up 12 per cent from this year’s lows in early March.

“Equity markets have been steadfastly ignoring the reality of tighter monetary policy and the end of zero per cent interest rates and central bank back-stopping of the party. It will be interesting to see in the coming months, the reaction of housing markets to policy normalisation, both in the US and abroad,” says Jeffrey Halley, Senior Market Analyst- Asia Pacific, Oanda.

Emerging markets (EMs), particularly India, have benefited from Fed’s balance sheet expansion, which the US central bank embarked upon from March 2020 to cushion the economic hit caused by the pandemic. In March 2020, its balance sheet size was about $4.2 trillion, which has more than doubled since then. The domestic markets have more than doubled during this period.

With the Fed moving from quantitative easing (QE) to quantitative tightening (QT) will the market give up some of the gains?

"It all depends on the next move by the Fed which is most likely to be a 50 basis points hike and tightening of the balance sheet. Markets haven't experienced a $1 trillion tightening. Investors are already worried about earnings now they have a possible recession to worry about. Markets are going to be volatile in the near future, " says Andrew Holland, CEO, Avendus Capital Alternate Strategies.

After pulling out over Rs 2 trillion since October 2021, the selling by FPIs had stemmed in the two weeks. However, with the Fed hawkish signals, the selling by overseas funds could once again accelerate. But experts say the impact won’t be catastrophic.

"Rising bond yields and Fed tightening could impact the rupee. This could lead to further selling by FPIs this quarter. However, equity markets will bounce back eventually. Returns given by many large- and mid-caps to FPIs are in high double digits over a three to five-year period. Even accounting for the currency depreciation the returns are huge and FPIs cannot afford to ignore Indian equities for long, " said G. Chokkalingam, Founder, Equinomics.