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The Taper Tantrum of 2013

The story dates back to the 2008 housing market crisis in the US. Banks had given out huge amounts in housing loans to people who couldn’t afford to pay it back. At the end of it, banks were left with huge amounts in unpaid loans, the stock markets had crashed. Eventually, a lot of money was lost in bad loans, crashed stock markets, and junk bonds. The global economy was crippled.

This is when the US Federal Reserve or the Fed, which is the central bank in the US comes into the picture. The US Fed announced Quantitative Easing(QE). In Quantitative Easing, the government is essentially pumping money into the economy. It does so by cutting interest rates, buying bonds from the market, policymaking, and other banking instruments. The Fed had the mission of refilling the banks and the economy with cash.

Remember, in bonds, as the demand for them increases, their price increases, and yield decreases, and vice versa. The Fed first bought all the short term US-Treasury notes from financial institutions, this decreased the short-term interest rates. However, the interest rate on long-term notes was intact. Soon, short-term interest rates on loans were almost close to zero. This is good for the borrower, but what about the lender? It’s bad news for the lender. The lender then has to search for other instruments yielding higher interest rates. Finally, The investors in the US found two solutions, the stock market and foreign investment in developing countries.

India wasn’t impacted much by the global economic crisis in 2008. Fairly so, India became an investment opportunity for US Investors. While the global flows had declined by 10.5% in 2008, Foreign Direct Investment(FDI) in India increased by 46% the same year. This was the case with many developing economies. They received foreign investment in huge amounts from already developed countries that were affected by the global economic crisis. These developing countries prospered from foreign investments.

Now comes the ‘Taper Tantrum’. Fast forward to 2013, the economy had revived, things were going pretty well all around the world, which is when the Fed announced that they were going to ‘taper’ or ‘wind down’ the Quantitative Easing(QE) or essentially stop pumping money into the system. While this was just an ‘announcement’ this sent ripples across the globe.

Now, foreign investment is much riskier than investing in local sovereign bonds. The announcement by the Fed to taper the Quantitative Easing made investors believe that the interest rates back home would go up. This would increase the incentive to invest in safer domestic instruments like bonds over foreign investment.

What was the Impact?

What was the impact of the announcement? Naturally, since the stock markets were overpriced, investors started withdrawing money from the stock markets. They also started withdrawing funds that were invested in the emerging markets. This caused economic turmoil in emerging markets across the world. Investors started exchanging the local currency (Indian Rupee) for the Dollar. This had a negative impact on the price of the Indian Rupee(INR) against the US Dollar(USD).

Since the government would stop buying bonds from the market, it was perceived that bond prices would decrease. Therefore, the bondholders started selling their bonds which lead to a decrease in price and increase in yield of bonds. This period was relatively short-lived and therefore called the ‘Taper Tantrum’. Even though the Fed had announced, it decided to hold back on its decision after the Taper Tantrum for some time.

Taper Tantrum Coming Back?

The economic situation in 2021 is similar to that of the economic crisis in 2008. When the taper tantrum occurred, sectors with high foreign investments, debt mutual fund holders, and bondholders were affected the most. Governments are intensively pushing stimulus packages and Quantitative easing programs to restart the economy. Stock markets are overpriced and a lot of foreign investors have shored up in emerging markets.

Finance Minister Nirmala Sitharaman said that India does not face a risk of Taper Tantrum, as it did in 2013 and that the ministry and RBI are vigilant enough to avoid the situation this time.

The last Taper Tantrum was a panic reaction from investors in a volatile market. It wasn’t correlated to any other macroeconomic factors in the past. The macroeconomic conditions of 2021 aren’t similar to that of 2013. Unlike last time, economists and bankers might have learned their lessons and a Taper Tantrum-like situation might not actually happen after all.

The United States Treasury Bond Yield has been showing a significant rise over the past week or so. On Thursday (March 4), the bond yield (or returns) rose to its highest level since 2015— 1.57%. The Dow Jones Industrial Average fell by more than 1% on the same day, while the S&P 500 nearly erased all of its gains made in 2021. As soon as the yield rates increase, we see markets crashing globally. You may recall that our Nifty fell by over 500 points last Friday (Feb 26) due to the same reason. Let us have a detailed understanding of this phenomenon.

A Breakdown of Events

Bonds are debt instruments that are issued by governments and corporations when they require funds. Bond yield is the fixed return that an investor gets on a bond or any particular government security. Amidst the Covid-19 pandemic, the US Federal Reserve had cut interest rates (on loans) to near-zero levels in March 2020. This meant that people could borrow more money from banks at cheaper rates. They could use this money for basic consumption and other requirements, and thus, kick the economy out of recession.

Once the US Fed cut interest rates, bonds became more attractive as they gave fixed returns. There was more demand for bonds, which led to an increase in bond prices. The higher a bond’s price, the lower will be its yield. This is because an investor who is buying a bond will now have to pay more for the same returns. As we know, people had also turned away from the stock market as panic had led to a collective sell-off during March-April.

The Current Scenario

In recent months, the situation has more or less turned for the better. The rate of infections has fallen and people are receiving Covid-19 vaccines. The $1.9 trillion stimulus package in the United States will also provide a well-needed boost for all economic activities. Due to these positive sentiments, investors had moved away from treasury bonds to riskier assets such as stocks (as it provided higher returns). This ultimately led to a fall in treasury bond prices and an exponential rise in bond yields to their recent highs.

Since the beginning of 2021, bond yields have surged from 0.9% levels to 1.57%. Higher yields in the US signal that the Federal Reserve might start to increase the interest rates to contain inflation. When economic growth starts to take off in the US, inflation will surely rise. The rise in interest rates will discourage people from taking loans, and there will be less market liquidity. If this happens, investing in stock markets can become riskier. Due to this fear, global investors started to panic and pulled out money from emerging economies such as India— where the economy is recovering at a relatively slower pace.

1-Day Chart of US Government Bond 10-Year Yield and Nifty 50. Source: TradingView

Large institutions felt it was time to invest more money into low-risk securities and balance their portfolios. They started to sell off their stocks and infuse more money into US Treasury bonds, which are now providing them with high/safe returns. This is why we have been seeing a huge sell-off in our Indian stock markets when there is a spike in bond yields.

Conclusion

The general mood in the Indian stock market was quite positive after the Union Budget 2021 presentation on February 1. We saw benchmark indices (Nifty and Sensex) hit record highs. However, the rising bond yields have now become a major concern for investors. We can also see bond yields rising in the United Kingdom and India as well. Markets have become highly volatile and unpredictable. The increase in bond yields has also impacted the currency market. The rupee closed at 73.47 against the US Dollar on March 1. This was the biggest single-day fall since March 2020. Gold prices have fallen heavily due to the same reason.

In the US, the Federal Reserve has outrightly stated that the recent rise in bond yields would not affect their existing policies. The Fed said that interest rates would be kept near-zero levels until the economy reaches full employment. This is positive news for stock markets, as lower interest rates for borrowings leads to better liquidity.

Many financial analysts have warned that markets could crash further if bond yields continue to rise. However, the recent GDP numbers show that India has made a strong economic recovery. All major sectors such as manufacturing, services, and real estate are showing rapid growth. These are very positive sentiments that would encourage investors to infuse more money into our stock markets (which is already in a bullish phase). Thus, the correction we are witnessing now will most probably be a short-term phenomenon. Do keep a close watch on both domestic and global developments while entering into trades.