After a brief pause, the US Federal Reserve is again expanding its balance sheet, thus continuing to support asset prices. The US central bank has added nearly $31 billion to its balance sheet in the last two weeks, and this could explain the encouraging start for equity markets in 2022.
The consolidated size of the Federal Reserve balance sheet reached $8,788.3 billion on Wednesday (January 12), up from $8,765.7 billion a week ago and just a notch below the all-time high of $8,790.5 billion on December 22, 2021.
In December, the US Fed reduced its balance sheet twice -- in the first and last weeks of the month. The Fed action was accompanied by a sell-off in equity markets, including in India, and a decline in emerging market currencies.
However, there has been a sharp rise in asset prices from their lows last month. The benchmark Nifty50 index, for example, is up nearly 11 per cent from an intra-day low of 16,410 in December. The index closed at 18,256 on Friday. The rise in Indian equities was accompanied by an equally sharp appreciation in the Indian rupee from a two-year low of 76.34 to a dollar, reached on December 15. The rupee closed at 74.16 against the dollar on Friday.
Analysts attribute the bullishness in the equity and currency markets to an unwinding of the Fed tapering trade.
“Traders in most markets had created many short positions in the months of December and November last year in anticipation of tapering by the Fed. These trades are now unwinding (or short-covering of positions), leading to a price recovery in most risk assets, including equities, commodities, and emerging market currencies," said Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity.
He expects the short-covering to end soon, leading to a weakness in the equity and currency markets once again.
Over the long term, he expects the Indian equity market to remain volatile and trend downward due to the monetary tapering by the Fed.
“Monetary tapering and the follow-rate hike by the US Federal Reserve will greatly slow down capital inflows in the Indian market, which will weigh on equity prices and the rupee-dollar exchange rate," he added.
Historically, there has been a high positive correlation between the changes in the US Federal balance sheet and the changes in the Indian equity markets.
The correlation coefficient between the size of the Fed balance sheet and the Nifty50 index has been 0.95 since the beginning of April 2020, translating into a rise or fall in the index in tandem with the changes in the Fed balance sheet.
The US Federal Reserve has expanded its balance sheet by around 20 per cent, or $1,425 billion, since the beginning of the 2021 calendar year. In the same period, the Nifty50 index is up around 30 per cent. The Fed uses these additional dollars to purchase financial assets such as US government bonds, mortgage-backed securities, and corporate bonds. This expands liquidity in financial markets and leads to a rally in bonds and equity prices.
According to the Federal Reserve timeline, it will cut its asset purchase programme by the month of March this year, and then start selling down its stockpile of bonds in a bid to shrink its balance sheet.
Other analysts, however, say tapering by the Federal Reserve will only have a minor impact on the Indian equity market. “The Indian market may actually outperform US equities in 2022 in constant currency terms as tapering by the Fed and the resulting higher interest rate will dry up share buybacks in the US market. Share buybacks funded through low-cost debt accounted for nearly 40 per cent of the rise in US equities in recent years,” said Shailendra Kumar, CIO of Narnolia Securities.