The US Federal Reserve has given a clear time frame for stopping its bond purchase program. The Fed said on Wednesday the 19th of June that it expects to wind down its bond purchase program by mid 2014. The Fed expects US unemployment rate to come off to 6.5% to 6.8% levels in 2014 from current levels of 7.6%. US economy is forecast to grow in a range of 3% to 3.5%. Inflation expectations are down with the Fed’s core inflation measure the Personal Consumption Expenditure (PCE) being forecast at 1.5% to 1.8% from earlier expectations of 1.7% to 2%.
The threat of Fed stopping bond purchases has lowered the value of your investments in Indian equities with the Sensex and Nifty falling by over 6% from highs and in bonds (bond funds) with bond yields rising by 20bps from lows. The question is will your investments continue to lose value when the Fed stops bond purchases? What should you do with your investments in equities and bonds, should you sell on worries of FIIs pulling out money from the country?
The answer is that you should hold on to your investments in equities and bonds even if the Fed stops its bond purchases. The Fed is withdrawing additional liquidity infusion into the system on better prospects for the US economy. The Fed however is not sucking out liquidity nor is it raising policy rates given that inflation in the US is trending at 1.1% levels, well below the threshold tolerance levels of 2% of the Fed. US unemployment rate at 7.6% for May 2013 is a whole percentage point higher than where the Fed would like it to be.
The end of bond purchases is good for global inflation expectations as threats of commodity price increases recede on withdrawal of cheap liquidity. Falling inflation expectations helps interest rates in economics such as India to come off leading to falling bond yields and rising equity prices.
The Fed is determining the value of your investments in a positive way than in a negative way. Short term volatility will always exist but that should not take away your long term perspective.
The US Federal Reserve (Fed) Chairman is truly powerful as his actions affect your investments. The reason that Ben Bernanke the Fed Chairman can determine the value of your investments in Indian assets including equities and bonds is the fact that the Fed is seen as a supplier of cheap liquidity to global financial markets. Global market players love cheap liquidity as it helps them make profits by borrowing cheap in US Dollars (USD) to invest in higher yielding assets and this includes emerging market currencies, bonds and equities.
The Fed has been buying USD 85 billion a month of assets including US Treasuries and Mortgage Backed Securities over the last six months. The Fed has also kept policy rates at close to zero percent. The Fed’s monetary actions have helped keep USD borrowing costs at the short end extremely low with six month libor at 0.41%. LIBOR is the benchmark USD lending rate across the globe. The markets were extremely comfortable in borrowing at Libor and investing in bonds of countries such as India where one year Treasury bill rates are at 7.30% levels.
The markets were suddenly jerked out of its complacence when in May the Fed Chairman voiced his thoughts of paring down bond purchases as the US economy was showing signs of stability. The economy was adding jobs, unemployment rate had come off, home prices were looking up, consumer confidence was high and inflation was tempered. The fact that a better US economy is good for the markets escaped the players as their one single focus was on the cheap liquidity donated to them by the Fed.
The result of the Fed speak in May was a steep correction in emerging currencies including the INR that touched all time lows, fall in equity prices globally and rise in bond yields both in India and across the globe. FII’s sold more bonds than what they bought in fiscal 2013-14 with net sales of USD 1 billion. FII’s had invested USD 5.5 billion in INR bonds in fiscal 2012-13.