After a brief pause, the US Federal Reserve is again expanding its balance sheet, thus continuing to support asset prices. The US central bank has added nearly $31 billion to its balance sheet in the past two weeks, and this could explain the encouraging start for equity markets in 2022.
The consolidated size of the Federal Reserve balance sheet reached $8,788.3 billion on Wednesday (January 12), up from $8,765.7 billion a week ago and a notch from an all-time high of $8,790.5 billion on December 22, 2021.
In December, the US Fed slashed its balance sheet twice – in the first and last weeks of the month. The Fed action was accompanied by a sell-off in equity markets, including India, and a fall in emerging market currencies.
However, there has been a sharp rise in property prices from last month’s lows. For example, the benchmark Nifty 50 index is up nearly 11 per cent from its intra-day low of 16,410 in December. The index closed at 18,256 on Friday. Along with the rise in Indian equities, there was an equally sharp rise in the Indian rupee to the dollar from a two-year low of 76.34 reached on December 15. On Friday, the rupee closed at 74.16 against the dollar.
Analysts attributed the rally in equity and currency markets to the end of the Fed tapering trade.
“Traders in most markets created several short positions in the months of December and November last year in anticipation of a tapering off by the Fed. These trades are now unwinding (or short-covering of positions), leading to price recovery in most risk assets including equities, commodities and emerging market currencies, said Dhananjay Sinha, managing director and chief strategist, JM Institutional Equity.
He expects the short-covering to end soon, which would once again lead to weakness in the equity and currency markets.
In the longer term, he expects the Indian equity market to remain volatile and trend downward due to monetary tapering by the Fed.
“Monetary tapering and subsequent rate hikes by the US Federal Reserve will significantly reduce capital inflows into the Indian market, impacting equity prices and rupee-dollar exchange rates,” he said.
Historically, there has been a highly positive correlation between changes in the US Federal balance sheet and changes in the Indian equity markets.
The correlation coefficient between the size of the Fed balance sheet and the Nifty 50 index has been 0.95 since the beginning of April 2020, which translates to an increase or fall in the index with changes in the Fed balance sheet.
The US Federal Reserve has expanded its balance sheet by nearly 20 percent, or $1,425 billion, since the start of the 2021 calendar year. The Nifty 50 index has gained nearly 30 per cent in the same period. The Fed uses these additional dollars to purchase financial assets such as US government bonds, mortgage-backed securities, and corporate bonds. This expands liquidity in the financial markets and leads to a rally in the prices of bonds and equities.
According to the Federal Reserve timeline, it will cut its asset purchase program by the month of March this year, and then begin selling off its reserves of bonds to shrink its balance sheet.
However, other analysts say the cut by the Federal Reserve will have only a marginal impact on the Indian equity market. “The Indian market may actually outperform US equities in constant currency terms in 2022 as the Fed taping and resulting higher interest rates will dry up share buybacks in the US market,” said Shailendra Kumar, CIO, Narnolia Securities. The share of share buybacks funded through low-cost debt to increase U.S. equities over the years is about 40 percent.