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Posted by: Deepa Vasudevan on Thu, May 23rd, 2013

Asset Purchases

Interpreting the News: Fed Speak on Asset Purchases Moves Markets

 

Asset purchases are in news due to two recent events.  Federal Reserve Chairman Ben Bernanke testified before a Congressional Committee on 22 May 2013, stating that the asset purchase policy would continue until unemployment reduces. This led to a rally in stock markets around the world. But he also suggested that the policy was flexible: a sustained improvement in the labour market could slow down purchases. Minutes of a recent Fed Policy meeting released on the same afternoon showed that some members were ready to begin reductions in purchases by June. Markets panicked, and major indices started sliding down.

 

What are asset purchases? The US Federal Reserve has been using various tools of quantitative easing (QE) to enable the revival of the US markets after the crisis of 2008.  Since the interest rates had already been brought down to zero, the Fed had to find new tools.  QE refers to the purchase of bonds (both Treasury bonds and mortgage backed securities) by the Fed.  These purchases put money into the system, earning the governor the name "Helicopter Ben".  Critics have pointed out that purchase of bonds by the Fed and the consequent flooding of markets with money may not lead to fast revival in the economy, but have harmful side effects particularly, an increase in asset prices world over.

 

The present asset purchase program began in December 2012, is a continuation of monetary easing (often known as QEIII) that was launched in September 2012. Fed had committed to (i) purchasing about $85 billion of long term mortgage backed securities and treasury securities each month, and (ii) holding long term rates at close to zero  until unemployment reduces. The aim is to keep long term rates low, encourage housing loans, and allow the lower interest rates to revive interest in other assets in the financial system. The final results - higher economic growth and employment - are the same as that expected from conventional reduction of interest rates to revive the economy. 

 

Between June 2008 and February 2013, asset purchases caused the Federal Reserve Balance sheet to grow from less than $1 trillion to about $3 trillion (the assets that were bought are held here).  The greatest impact of this purchase program has been on global financial flows. Liquidity created when Fed buys bonds from the market, and pays for them in dollars has moved to other global and emerging markets in search of higher returns, resulting in rising stock markets and property prices. Even India, despite the threat of a ratings downgrade, managed to attract net foreign inflows of $50 billion in FY 2013 (a remarkable 22% increase over last fiscal!).

 

Consequently, investors are extremely sensitive to any signal that asset purchases may stop, or even slow down.  The asset purchase policy it now seems, would be tuned based on the data about economic revival and employment. Even the monetary policy committee seems to be holding a similar view. Any pause in the program would plug liquidity, and asset prices would correct. That is the fear the markets seem to be playing out.

Deepa Vasudevan on Mon, May 27th, 2013 1:58:22 pm

Dear Mr.Ayyar, You are right about the general market nervousness: factors such as the Euro area crisis, and US troubles- the slowdown, the fiscal cliff, QEIII and the mode of exiting from it; contribute to it. You are right also that CAD is easing with falling gold and oil prices- but it continues to be higher than sustainable levels. Factors that keep CAD high include slowing exports; and high gold imports despite imposition of duties. The link between QE and CAD is obvious to the market: if QEIII was to be slowed or withdrawn, the foreign inflows that have comfortably financed CAD will reduce. It is this fear that made Indian markets react so adversely to the Fed communication last week.

Dr D Sundararajan on Sun, May 26th, 2013 6:45:16 pm

A very informative article. FII's have pumped in record money into Indian stock markets in this calendar year so far; which has taken the stock market to 30 month highs; however this has had little impact on the external value of the Indian rupee; this is disturbing; on the contrary Re has depreciated over the last few days substantially. Current account deficit - thanks to high gold imports is indeed a matter of grave concern. It is scary to imagine what would happen should the FII flow slow down.

P K Ganesh Ayyar on Sun, May 26th, 2013 10:44:27 am

Hi Deepa, Your analyses of the reasons for the markets reacting adversely to Mr BB's lack of clarity on his proposal provides the insight, but a few grey areas still persist. Possibly, you could throw more light on them. 1. While the Fiscal Cliff issue was temporarily resolved on 1st Jan by buying more time, it has not been comprehensively resolved. Markets are still nervous, and hence over react to even news which could affect value of the dollar. 2. The crash of Gold prices reflect the sudden reversal of fortunes for the downward spiral of the dollar, which again explains the reason for Rupee weakening. 3. An increase of 22% in the $ inflow in 2013 over 2012 should actually result a stronger Rupee, with no additional pressures on FII selling stocks. This has not manifested itself, particularly given that the net inflow of $ is positive, and the CAD is easing with crude and gold prices dropping. In light of these (amongst other) reasons, what is the real impact of the QE III, and Mr. BBs latest fuzzy move???

Shrinil Shah on Sun, May 26th, 2013 10:09:26 am

Thank you very much Ms. Vasudevan. The analysis is enlightening one. But i request you to kindly also put your thoughts on the market behaviour in such circumstances in short run as well as in long run.

KISHORE J BHARMANI on Sun, May 26th, 2013 9:33:48 am

LOGICALLY GOOD BUT POLITICALLY ECONOMY DOES NOT RUN LOGICALLY. IF IT FED REVERSE QE GOOD FOR ALL CONTRY. EXCESS LIQUITY REMOVE FROM THE SYSTEMS AND BENEFITED TO END USER. THAT IS REAL ECONOMY AND REAL PLITICS.

Rajeswaran P on Sat, May 25th, 2013 5:16:12 pm

Deepa Vasudevan has excellently explained QE - the point of concern is that markets react very agressively on issues like this - certainly is a matter of concern - , without attaching due importance to the valuations of stocks, corpoate performances etc. Well that has become the order of the day.

R n guru simha on Sat, May 25th, 2013 4:49:09 pm

The rupee has to gain over dollar but is not happening even though our economy is doing better than us. I feel the consrajint of RBI is better than the us policy of flooding with cash T

Deepa Vasudevan on Sat, May 25th, 2013 9:35:50 am

Dear Mr.Roy, Your are absolutely right in concluding that liquidity is important, but it is unlikely to overshadow valuations in the medium or long term. Dollar inflows in the past year have actually slowed Rupee depreciation (the same thing as causing appreciation); from levels of Rs.55/US$ in December 2012, the exchange rate had stabilized at around Rs.53-54 since March 2013. Indications of a sudden withdrawal of QE is a threat to inflows on the capital account, which are necessary to balance the 4-5% current account deficit India is likely to post in 2012-13. When the US Fed hinted at slowing liquidity, the market reacted by pulling down the rupee to about Rs.55.61/$ by end of this trading week. If India's fundamental valuations were sound, then this would only be a short term market reaction. However, if the current account deficit persists in this fiscal year, and other parameters (GDP growth, fiscal deficit, revenue deficit, reforms initiated) do not improve, then the depreciation could continue or worse.

Harshil Roy on Fri, May 24th, 2013 4:47:59 pm

Hi, Nice article, but some queries, Why this dollar inflow does not result in rupee appreciation? Does your article indicate that our market will be down again,if QE is withdrawn or slowed down, resulting into higher interest rates outside India? If this is the right logic then every thing evolves around where liquidity is directed rather than the valuations of the assets.

Timmana Gouda D on Thu, May 23rd, 2013 8:55:25 pm

Good analysis..

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