On tap, the US Fed stuck to its schedule. It launched the program in early January and quickly completed it by the end of March 2022, dropping new bond purchases to zero. Now, it is on the rise and the balance sheet is shrinking With the financial tightening in terms of balance-sheet declines between July-August, what happened in the previous stimulus cycle to understand what lies ahead will not be out of place.
Looking back, in the previous Fed stimulus cycle (post-Global Financial Crisis), although the taper started in 2013, by the end of 2017 the Fed really began to take serious steps to shrink its balance sheet. For the unconventional, taper means reducing the size of fresh bond purchases, while reducing balance sheets means allowing previously purchased bonds to mature without repurchase. As is well known, the latter has a huge impact on the market because the extra stimulus is drawn by allowing the bonds to mature without repurchasing liquidity. Thus the Fed reduces the size of its balance sheet after each stimulus cycle.
Again, the Fed has ambitious plans to shrink its epidemic stimulus in the coming months, with plans to shrink its balance sheet to a larger size. According to some estimates, this could, in all likelihood, start with-25 billion a month in July-August and gradually accelerate to $ 95 billion by the end of December 2023.
If so, someone is talking about taking more than 1.7 trillion of liquidity out of the system in 18-19 months. In terms of that, it would be almost three times the 60 660 billion that was pulled in the previous cycle in 2018-19.
By any scale, it’s a huge unwinding. The earth has never seen such a massive expansion in the past. Of course, the scale may not seem exciting compared to what was pumped during the epidemic (close to $ 5 trillion). As the Fed’s balance sheet expands from $ 4 trillion to close to $ 9 trillion during the epidemic, a gradual decline over the extended period can probably be expected for the best results. Nevertheless, markets are naturally concerned about whether FIIs will ever return to emerging markets during this period. Given this huge overhang of the liquidity challenge for the foreseeable future, it may seem realistic to assume that FIIs are unlikely to return any time soon, especially after their massive departure from India in October 2021. For the record, they have pulled in over $ 23 billion (net sales) since then.
This is where peeking into past liquidity cycles can give you some interesting insights into how FIIs behave in similar situations. Let’s go back and look at the period between January 2018 and August 2019. During this time, the Fed reduced its balance sheet by গড়ে 660 billion, averaging $ 30 billion per month (the exact amount varied from a low of $ 16 billion to a high of $ 61 billion in different months).
Dividing this period into two helps to understand how FII’s behavior has changed. Initially, as the Fed began unwinding, FIIs started pulling in February 2018 and accelerated their pace in the middle of the year to reach the top at some point in October-November 2018. But, what happened in the post is even more interesting. Until this period, the Fed’s unwinding was about $ 30 billion per month, which was later increased to $ 38 billion per month from January to August 2019. Ironically, after the monthly unwinding increase from the Fed, the FII flow reversed and there was a huge amount. More than $ 13 billion in net flow during that time. It should not be forgotten that during this period, the Fed pulled in more than 300 billion to reduce its balance sheet.
So, what is the conclusion from this one? Is there a correlation between the Fed’s unwinding and FII flows? Of course there is a correlation in the beginning, but not much later. More importantly, the more interesting thing is that the flow in the latter part was twice the outflow in the initial part. Having said that, it is also important to remember that no two cycles will be the same. Although the broad pattern may be similar, it can be difficult to predict exactly at what point the tide will change for FII flow. But more importantly, FII money will return much sooner than the Fed’s timeline. Not only will it be quicker, but it will be much bigger than what came out. This is one of the reasons why some mature investors are expecting a bull-run for the Indian market next year (2023).
From this perspective, the current weakness, which could last for several months due to the Fed’s rate-rise and balance-sheet-shrinking overhang, is a great opportunity for long-term investors to wrap up their position, especially in the days of scattered panic that will often come.
(Arunagiri N, Founder, CEO and Fund Manager of Trustline Holdings.)