US Fed prepares for tapering or Officials say tapering is near. These are some things investors hear often. But let's first understand what exactly is tapering.
Tapering is basically a process of gradually reducing and eventually stopping the purchase of assets by central banks. So basically, when a central bank starts tapering, it is reducing the monetary stimulus it is providing to the system and tightening the monetary policy.
Tapering also leads to an increase in interest rates. So when the US Federal Reserve says that tapering is near, it is a general indicator of rate hikes in the near future.
So how does it affect Indian stock markets?
Now, when the US Fed hikes rates, especially if it is unexpected or earlier than forecasted, it leads to a strengthening of the dollar and thereby weakening of the rupee. It also leads to a rise in bond yields.
Another major impact of the Fed rate hike is a withdrawal of funds by foreign institutional investors (FIIs). When the Fed hikes rates, FIIs shift from investing in emerging markets to US Treasuries and this outflow from equity markets cause them to decline.
The hike reduces risk appetite and increases volatility in Indian markets, however, if the hike is planned and expected, the market's price in the hike and hence the disruption is contained.
So usually in the case of a sudden, unplanned, or earlier than expected hike, an investor must be ready for a knee-jerk reaction and some initial losses.
With the latest taper scare, Chris Wood of Jefferies believes that Indian markets are likely to underperform global peers in case of a global taper scare, however, he continues to remain structurally positive on the Indian equity markets despite that.
How are bonds and rupee affected?
The hikes in interest rates lead to a rise in bond yields for US treasuries. This in turn decreases the difference in rate between Indian bonds and US bonds making the latter more attractive thus leading to FII outflows.
Also, a rise in interest rate leads to weakening of the rupee as the dollar strengthens, as mentioned earlier. However, this decline in the rupee leads to lower investment returns for foreign investors as the rate of change from rupee to dollar becomes expensive. This also leads to outflows of foreign funds in India.
Will rate hikes in the US prompt the same here?
Even though India has an independent monetary policy mainly based on maintaining retail inflation at a certain level. Weakening in rupee may lead to a rise in import costs which can lead to higher inflation, hence forcing the RBI to increase the rate.
Thus, a rise in US fed rates is considered an important variable while deciding interest rates in India. Experts believe that if the economic rebound is strong in India, the impact of a rate hike in the US and some inflationary pressure back home can be easily handled without rising rates in India. However, Morgan Stanley said that it expects RBI to increase interest rates in the first quarter of 2022.
Now that we understand tapering and its effect on interest rates and the markets, one must be mindful of the timing of the rate hike before making any investment decisions. You can easily book profits or buy on dips based on the US Fed's decisions.