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US Fed tapering and its impact

To understand tapering, we need to know what is Quantitative Easing or QE.

Quantitative Easing (QE):

Quantitative easing (QE), involves the Central Bank of a country buying fixed-income

securities in the open market, in order to infuse liquidity and bring down interest rates,

to stimulate the economy. The Fed has enacted three different rounds of QE since the

2008 financial crisis. In the most recent iteration, it purchased $85 billion of fixed-

income securities every month - $40 billion of mortgage backed securities and $45

billion of U.S. Treasuries – through till end December 2013.

Beginning January 2014, the Fed began to taper the policy in increments of $10 billion.

The Fed’s Current Policy-Sep. 2014:

The Fed’s bond buying program currently stands at $25 billion, and after the latest

meeting, it will go down further to $15 billion.

They have also clearly indicated that subsequent rate actions would be data dependent.

i.e. if the economy improves (focus on employment), rates will head higher. ‘When’

remains the million dollar question.

Analysts are expecting that Fed may start to raise interest rates from mid 2015. US

unemployment rate has fallen from a peak of 10% to 6.1% currently.

Impact of Tapering and Rate Hike:

The direct impact will be the US 10 year benchmark government bond yield , currently

at a level of 2.5 percent, to go up to a level of 3-3.5 percent. This will make large

investors like pension funds, insurance companies to invest more in US sovereign

bonds, instead of investing in risky assets. There could be a selloff in global equity

markets, and liquidity will go back home (USA).

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Secondly, when liquidity starts to flow toward US bonds, then the dollar will appreciate

against all the major currencies, a trend already evident today.

We can see in the above dollar index chart that the dollar has appreciated from a level

of 80 to 85.64 in last 1 year. This is happening when Fed has only done tapering; still

they have not increased the rates. When rates will go up in next year then we can

expect further appreciation of the dollar against all major currencies.

The FLIP side:

Commodity prices (incl. oil) will remain subdued (as they are denominated in dollars)

due to the strength of the dollar. This will benefit countries like India.

The European central bank (ECB) and Bank of Japan (BOJ) are still maintaining an

expansionary monetary policy, and China has also begun its version of QE. So the

question is – is the fear overdone? – The system as a whole should still remain flush

with funds, thanks to BOJ and ECB.

Dollar Index Chart