In May 2013, the US Fed’s announcement that it would taper its massive bond-buying programme that had been on since the global financial crisis 2008 led to a sudden sell-off in global stocks and bonds.
This triggered capital outflows and currency depreciation in many emerging market economies that received large capital inflows. This episode earned the nickname taper tantrum.
What Is Quantitative Easing (QE)?
Any economy may subjected to slow down at some point of time. To boost up the economy of the country, Central bank may adopt different strategy. The objective is mainly to increase flow of money into the market which will be invested to increase economic output.
Quantitative easing (QE) is a form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply and encourage lending and investment.
- Quantitative easing was first developed by the Bank of Japan (BoJ) but has since been adopted by the United States and several other countries
The Taper Tantrum of 2013
The story dates back to the 2008 housing market crisis in the US. Banks had given out huge amounts in housing loans to people who couldn’t afford to pay it back.
- At the end of it, banks were left with huge amounts in unpaid loans, the stock markets had crashed. Eventually, a lot of money was lost in bad loans, crashed stock markets, and junk bonds. The global economy was crippled.
This is when the US Federal Reserve or the Fed, which is the central bank in the US comes into the picture. The US Fed announced Quantitative Easing(QE).
- In Quantitative Easing, the government is essentially pumping money into the economy. It does so by cutting interest rates, buying bonds from the market, policymaking, and other banking instruments. The Fed had the mission of refilling the banks and the economy with cash.
Remember, in bonds, as the demand for them increases, their price increases, and yield decreases, and vice versa.
- The Fed first bought all the short term US-Treasury notes from financial institutions, this decreased the short-term interest rates. However, the interest rate on long-term notes was intact.
- Soon, short-term interest rates on loans were almost close to zero. This is good for the borrower, but what about the lender? It’s bad news for the lender.
- The lender then has to search for other instruments yielding higher interest rates. Finally, The investors in the US found two solutions, the stock market and foreign investment in developing countries.
India wasn’t impacted much by the global economic crisis in 2008. Fairly so, India became an investment opportunity for US Investors. While the global flows had declined by 10.5% in 2008, Foreign Direct Investment(FDI) in India increased by 46% the same year.
- This was the case with many developing economies. They received foreign investment in huge amounts from already developed countries that were affected by the global economic crisis. These developing countries prospered from foreign investments.
Now comes the ‘Taper Tantrum’. Fast forward to 2013, the economy had revived, things were going pretty well all around the world, which is when the Fed announced that they were going to ‘taper’ or ‘wind down’ the Quantitative Easing(QE) or essentially stop pumping money into the system. While this was just an ‘announcement’ this sent ripples across the globe.
- Now, foreign investment is much riskier than investing in local sovereign bonds. The announcement by the Fed to taper the Quantitative Easing made investors believe that the interest rates back home would go up. This would increase the incentive to invest in safer domestic instruments like bonds over foreign investment.
Current Context
The 10-year US Treasury yield has witnessed a sharp rise this year too — from 0.9 per cent to 1.4 per cent so far in 2021.
Bond yields globally, including in India, have been trending up. The post-Covid period was marked by massive fiscal spending and substantial monetary easing by the US and other economies. The $1.9 trillion stimulus package proposed by Joe Biden is the latest in the series.
But as expectations of a stronger economic recovery have gained ground, inflation in commodities has been rearing its head. The possibility of inflation has also fueled concerns that the US Fed will have to reverse its quantitative easing and raise interest rates sooner rather than later.
Yield is Inversely proportional to Bond Price.
- Decrease in Bond Yield means it will offer less Interest rates due higher Bond Prices and Motivate Investor to invest in other medium such Equities but if Us Treasury yields are increasing then Investor would prefer safe investment like US Treasury Bonds.
Why is it important?
The last time when US Treasury yields rose sharply in 2013, it triggered an outflow of capital from emerging market economies spread over several months beginning in May 2013.
- In India, foreign institutional investors pulled out money from both equities and bonds.
- The rupee depreciated over 15 per cent between May 22 and August 30, 2013.
- This forced the RBI to suddenly raise interest rates to stem the outflows.
When yields on the ultra-safe US treasuries rise, investors have reduced incentive to invest in riskier assets such as equity.
- Also, with equity valuations running sky high especially in tech stocks, the surge in yields seemed to have provided just another nudge to equity investors to book profits
- Hardening US Treasury yields reduce the yield differential with other countries’ bonds, making them less attractive.
- Which ultimately trigger an outflow of capital from emerging market economies
What does a rise in bond yield mean?
If one has to explain in simple terms, bond yield means the returns an investor will derive by investing in the bond.
The mathematical formula for calculating yield is the annual coupon rate divided by the current market price of the bond.
Therefore, there is an inverse relationship between the yield and price of the bond. As the price of the bond goes up, the yield falls; and as the price of the bond goes down, the yield goes up.
Current Yield=Bond PriceAnnual Coupon Payment
When investors buy bonds, they essentially lend bond issuers money. In return, bond issuers agree to pay investors interest on bonds through the life of the bond and to repay the face value of bonds upon maturity
If a bond has a face value of Rs. 1,000 and made interest or Annual coupon payments of Rs. 100 per year, then its coupon rate is 10% (Rs.100 / Rs. 1,000 = 10%).
Lets' Under why Bond Yield will Increase through Indian Scenario
In India, the yield of 10-year government securities (G-Sec) is considered the benchmark and shows the overall interest rate scenario.
This year, G-Sec yields have gone up compared to the previous year after the Centre announced its increased borrowing programmes in Budget 2021.
As government borrowing goes up, the supply of bonds in the market goes up, putting pressure on prices.
The government has announced a borrowing of ₹12 trillion in FY22.
Reference Sources : NewsFeed, BL, Investopedia
