Market Volatility through the Lens of Liquidity

With rupee hitting all time new low, turmoil in the equity market, huge yields turbulence and crude prices soaring, the current situation looks similar to September 2008. The only difference is this time the punch is on the Emerging market and not on the Developed economies.

The multiple defaults by IL&FS and its conglomerate have raised concerns over reliability of Money Market instruments like commercial papers by NBFCs. It has exposed loop holes in the working of NBFCs and the Indian bond market, resulting into shooting up of borrowing costs for NBFCs. Fear mounted that the leading NBFCs who were to refinance their short-term debt might face a sharp spike in costs or even a freeze in funding in coming months. Despite the increasing role of corporate bonds in recent times, a single default (IL&FS) may virtually dry up funding for the entire sector.

While the event has made headlines, it is concealing the reality of tightening domestic liquidity, which is surrounded by the ongoing balance of payment stress. This is not an India specific issue, but an emerging world-wide reality triggered by Fed’s quantitative tightening.

So now we, first understand what is Quantitative tightening?

Ten years ago in 2008, the world faced its worst economic crisis since the Great Depression. The contagion, which found its roots in the U.S. housing market quickly spread to the U.S. financial sector, and then to the global financial sector. It had affected the investment banks, insurance companies, commercial banks, mortgage lenders, and a number of companies who relied on credit in the US. The crisis was followed by global economic downturn.

In the wake of the global financial crisis, the Federal Bank launched Quantitative Easing (QE), which is an unconventional monetary policy in which a central bank purchases government bonds and mortgage-backed securities from the market in order to get the economy back on track. By this, the Fed started growing its balance sheet and infused trillions of dollars in the economy. QE has been effective in sailing the U.S. through the recession. In 2014, the Fed stopped increasing its stockpile of bonds and now it’s shrinking its balance sheet.

After years of QE the Fed is now roiling Quantitative Tightening (QT). In QT, the Fed is allowing billions of bonds it had bought during QE to now mature every month, rather than continuing to roll them over. This ultimately takes money out of the financial system. The Fed describes this as winding down of its balance sheet as part of a “normalization” of its policy. The combined impact of QT and rising Fed rates is creating a dollar liquidity squeeze worldwide.

Apart from the QT effect, the overall global sentiments are currently edgy because of risks like high crude oil prices, trade war and European Union’s political concerns. During such situation investor’s start panic selling, parking aside the basic fundamentals. The Emerging markets are already feeling the heat under its impact. In such a scenario, the Indian market and the economy cannot remain unharmed.

Reasons for liquidity crunch in the Indian market:

QT is causing liquidity disruptions. Even though for easing the situation, RBI is undertaking easing steps like Open Market Operations for injecting liquidity but since there is Current Account Deficit, this step may further strengthen the dollar.
FII rush to exit their investments and are pulling money out of India to invest elsewhere resulting into steady outflow of capital.
An increase in Fed rate causes higher repo rate in India which in turn leads to rising yields and higher cost of borrowings for the corporate, adversely affecting the investment scenario and growth prospects of the country.
Putting all this in a basket along with the ongoing NBFC issues we can conclude, liquidity impact market volatility directly and indirectly.

So as an investor what to do in such a scenario?

There are strong global headwinds which are transitory. India’s growth is poised looking at strong set of fundamentals and earnings growth. The current situation is a short term hiccup. Going forward in short term there could be correction in market because of upcoming elections. Investors instead of getting carried away by the volatility may adopt “stay invested and relax” strategy and wait for the best.

-Latika Jetha

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