The Taper Tantrum Series: Understanding its Fundamentals

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This is part one of the two-part series, in which I explore one of the major short-term risks facing India’s equity market in the not-so-distant future.

This risk is popularly called “taper tantrum” and you’ll hear it more often in the following months as the global recovery gathers pace.

At the outset, please note that this is meant to be a simplistic discussion, primarily aimed at enlightening the fundamentals of taper tantrum and its potential impact on India’s stock market. It is not intended at delving into the finer, more nuanced aspects of the monetary economics – which is better left to monetary experts.

That said, it is imperative for every investor to be fully cognizant of this risk – it played out in 2013, when Nifty slumped by close to 18% and could play out similarly in the future as well.

What is Taper Tantrum?

Before discussing this term, we first need to understand how two policies – monetary policy and fiscal policy – work.

Remember that economies normally tend to operate in cycles of peak and trough. For our purpose, let’s begin with trough — in the image below, this trough (or bottom) is marked by point A i.e., the economy is in recession.

When an economy is in recession, the government – in coordination with the central bank of the country– must figure out a way to (1) arrest the degrowth (2) boost growth.

The government does this through managing what we call the “fiscal” policy. In simple words, fiscal policy works through two fundamental tools. One, taxes. Two, spending.

To boost the economy, the government may reduce taxes so that people and corporates have more money in their bank accounts to spend.

More spending by them, in turn, results in higher employment and income.

Besides taxes, the government may also boost the economy by increasing its public spending. But on what? Primarily on building infrastructure such as bridges, canals, highways, railway, airports, and so forth.

This spending in turn results in greater employment – as more people are hired in projects – and therefore also national income.

So, as you see, the government may use fiscal policy to manage economic growth.

But besides the government, there’s also the central bank to the rescue. In the US’s case, it’s the Federal Reserve (or Fed) and in India’s case, it’s the Reserve Bank of India (RBI).

Just as the government uses fiscal policy to spur the economy, the central bank uses what we call the “monetary policy”.

Monetary policy – as the name suggests — involves using “money” to stimulate economic growth.

How? By using two tools: Interest rate and money supply.

When the economy is slowing down, the central banks reduce interest rates in the economy or increase money supply in an attempt to make it cheaper for individuals as well as companies to borrow (on credit).

Higher borrowing (at low interest rates) in turn helps companies tide over short-term disruption to demand for their products. They are able to pay interest on existing loans through new loans or even pay operational expenses such as salaries through cheap borrowing. Thus, lower interest rates help the economy stand up again.

How do central banks reduce interest rate?

Either directly through reducing what we call the “benchmark” interest rate – in India, this is the repo rate – or indirectly, through purchasing treasury bonds from the open market.

For those who are new to this, the repo rate is simply the rate at which commercial banks, such as HDFC or Kotak or SBI or ICICI, borrow money from the RBI. Currently, this is at 4%.

The logic is simple: If the commercial banks can borrow money at cheap rates from the RBI, they will in turn lend at cheaper rates to their customers – you and me.

This would reduce the lending rates across the economy. More people borrow, more people will spend. Higher spending (demand) in turn will mean higher production of goods and services, and therefore higher economic growth.

Alternatively, the central bank can also indirectly reduce interest rates through increasing money supply in the economy.

Higher money supply – through printing money – also indirectly leads to lower interest rates as banks now have more money to lend and they must encourage more people to borrow through reducing interest rates on home loan, personal loan, and so forth.

But of course, the central banks do not simply print money and distribute it amongst banks for free (remember there is no free lunch). They take “something” from banks in exchange for this new money. That something is “treasury bonds”.

What are treasury bonds?

Whenever the government wants to borrow for its needs, it goes to investors (you, me, or banks) and says, “Hey, if you lend me money for a few years, I’ll pay you 6% interest every year.” This arrangement is called a bond. And treasury is simply a word denoting the government.

Note that since the central government is the borrower, this loan is considered to be the most secure – it may rarely default on interest payments.

In exceptionally dire circumstances, it may simply print more money to pay interest on loan.

So, as you may realize, since treasury bonds are considered to be the safest (risk-free), the central bank buys these from banks in exchange for giving them newly printed money.

This is exactly what the US Fed did in the aftermath of the 2008 recession. From 2008 to 2013, the US Fed bought treasury bonds worth $2 trillion from the market.

This is to say that it injected $2 trillion of new money into the economy, thus reducing interest rates to close to 0 % over the 5 years.

Whether this injection of new money in the economy over those 6 years succeeded in boosting lending and thus demand in the US economy is still an issue of hot debates among economists.

But one fact is hardly contested: The creation of an equity market bubble. Note that higher money supply may not just reflect in higher demand for goods and services (the “real” economy).

This new money may also flow into equity markets (the “financial” economy), thus leading to a bull market for years to come.

In the US, for instance, the Dow Jones climbed by over 130% from 2009 to 2013. This newly created, cheap money also flowed from the US to emerging economies such as India and Brazil.

In India, the strong flow of foreign institutional and portfolio investment led the Nifty 50 to climb by 176% over 5 years.

This flow continued until 2013, when the US Fed signaled that it would gradually reduce buying treasury bonds — in effect, reduce printing new money – as the US economy had recovered markedly since the recession of 2008.

Merely the Fed’s signal was enough to send global equity markets into a tailspin.

India’s Nifty 50 fell by a sharp 18% in 2013 – most of it in 3 months from June to August 2013.

This event, in financial history, is known as the taper tantrum – the US Fed’s decision to “taper” the printing of new money and the equity markets “tantrums” in response to the Fed’s decision.

In the second part, we discuss why taper tantrum is negative news for the economy as well as stock markets.

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Harsh Vora

Harsh Vora

Harsh Vora is a proprietary investor & day trader with more than 10 years of experience in financial markets. He is a finance graduate from the Marriott School of Management, BYU and a public policy graduate from The Takshashila Institution, Bangalore, where he won the best academic performance award. Occasionally, he teaches economics to its students.
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