Central Bank balance sheets across the world have expanded rapidly in the last 8 years since Lehman Brothers went bust in late-2008. Just to share a piece of statistics; the US Federal Reserve holds bonds worth $4.5 trillion in its balance sheet while the European Central Bank (ECB) holds almost an equivalent amount of bonds to the tune of €4.1 trillion. The key point to note is that these central bank balance sheets have expanded exponentially in the last 8 years. The Chart below depicts how the central bank balance sheets of the Federal Reserve, ECB and the Bank of Japan have expanded since the Sub-Prime crisis first broke out in late 2007
The decision to infuse liquidity into the world economy was a globally synchronized decision and the decision to shrink the balance sheet is also likely to be a globally synchronized decision. If the US Fed starts to shrink the balance sheet then the BOJ, ECB and the Bank of England are likely to follow suit to avoid the risk of monetary divergence.
If that happens it will lead to an unwinding of the asset rally that we have seen since 2009, at least partially. Let us understand this little better! Post the sub-prime crisis, most global markets lost nearly 40% of their value in the next 18 months. But post-2009, the pick-up in asset values and equity markets has been substantial, largely due to liquidity infusion. Both the Dow and the NASDAQ recently touched all-time highs and so did the Nifty. That rally is likely to partially unwind as liquidity goes out of the system creating tightness in markets.
As the US Fed and other central banks shrink their balance sheets, we could see a rise in treasury yields. A rise in treasury yields will force the Fed to go slow on rate hikes as yields may have already gone up due to the Fed’s balance sheet shrinkage. As yields in the US go up, the yield spread with the Indian benchmark will narrow further. To prevent outflows of FPI debt and equity flows, the RBI may be inclined to hike repo rates. In fact, the MPC has already hinted at that possibility.
There are 2 things that Indian markets will have to be cautious about in this scenario. Firstly, the narrowing yield differential could lead to a surge in FPI outflows and a consequent weakness in the INR. In the past have seen this cycle play out. Secondly, as liquidity unwinds from the global system, a lot of stretched valuations may come under pressure. We may see additional pressure on mid-cap stocks and high beta names and even on other asset classes.
It is clear that the tapering of the central bank balance sheets is likely to happen sooner rather than later. Investors in India need to be cautious considering that it could have a much bigger impact on India compared to any Fed rate decision.