U.S.A Monetary Policy Impacts Indian Markets

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Ben Bernarke comment on QE3 Monetary Policy Quantitative Easing (QE) United States QE1, QE2, and QE3 Relationship between Bonds & Interest Rates Impact on Indian Debt Market Impact on Indian Rupee Impact on Equity Market

Ben Bernarke comment on QE3

On June 19, 2013, Ben Bernanke announced a "tapering" of some of its QE (Quantitative Easing) policies contingent upon continued positive economic data.

Specifically, he said that the Fed would scale back its bond purchases from $85 billion to $65 billion a month during the upcoming September 2013 policy meeting.

He also suggested that the bond buying program could wrap up by mid-2014.

Source: Google (Wikipedia)

Monetary Policy

Monetary policy is the process by which the monetary authority of a country controls the supply of money.

Monetary policy differs from fiscal policy, which refers to taxation, government spending, and associated borrowing.

This is often targeted by: Reducing Interest Rates OMO (Open Market Operations)

Quantitative Easing (QE)

Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when standard monetary policy has become ineffective.

A central bank implements quantitative easing by buying financial assets from commercial banks and other private institutions, thus increasing the monetary base.

This is distinguished from the more usual policy of buying or selling government bonds in order to keep market interest rates at a specified target value.

United States QE1

In late November 2008, the Federal Reserve started buying $600 billion in mortgage-backed securities.

Reached a peak of $2.1 trillion in June 2010

After the halt in June, holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012.

The Fed's revised goal became to keep holdings at $2.054 trillion.

To maintain that level, the Fed bought $30 billion in two- to ten-year Treasury notes every month.

United States QE2

In November 2010, the Fed announced a second round of quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011.

The expression "QE2" became a ubiquitous nickname in 2010, used to refer to this second round of quantitative easing by US central banks.

Retrospectively, the round of quantitative easing preceding QE2 was called "QE1".

Similarly, "QE3" refers to the third round of quantitative easing following QE2.

United States QE3

A third round of quantitative easing, QE3, was announced on 13 September 2012.

Federal Reserve decided to launch a new $40 billion per month, open-ended bond purchasing program of agency mortgage-backed securities.

According to NASDAQ.com, this is effectively a stimulus program that allows the Federal Reserve to relieve $40 billion per month of commercial housing market debt risk.

On 12 December 2012, the FOMC announced an increase in the amount of open-ended purchases from $40 billion to $85 billion per month.

Relationship between Bonds & Interest Rates

Interest rates and bond prices have what's called an "inverse relationship“.

The question is: how does the prevailing market interest rate affect the value of a bond you already own or a bond you want to buy from or sell to someone else? The answer lies in the concept of "opportunity cost”.

Investors constantly compare the returns on their current investments to what they could get elsewhere in the market.

As market interest rates change, a bond's coupon rate – which, remember, is fixed – becomes more or less attractive to investors, who are therefore willing to pay more or less for the bond itself. Let's look at an example.

Suppose the ABC company offers a new issue of bonds carrying a 7% coupon. This means it would pay you $70 a year in interest.

After evaluating your investment alternatives, you decide this is a good deal, so you purchase a bond at its par value, $1,000.1

What if Rates Go Up?

If new bonds costing $1,000 are paying an 8% coupon ($80 a year in interest), buyers will be reluctant to pay you face value ($1,000) for your 7% ABC bond.

In order to sell, you'd have to offer your bond at a lower price – a discount – that would enable it to generate approximately 8% to the new owner.

In this case, that would mean a price of about $875.1

What if Rates Fall?

Similarly, if rates dropped to below your original coupon rate of 7%, your bond would be worth more than $1,000.

It would be priced at a premium, since it would be carrying a higher interest rate than what was currently available on the market.

Impact on Indian Debt Market

It is understandable that the comments from Ben Bernarke would have an impact on USA Debt Market.

As one of the strongest Central Bank is reducing the buying of debt, this suddenly impacts the psychology of the US citizens to withdraw their money from the US Debt market.

But let us understand how it impacted the Indian Debt Market, which hit a lower circuit the other day after Ben Bernarke’s comment on QE3.

Considering the inverse relation between the Debt and the interest rates, Interest rates in US would go up and hence the FII’s in India who have invested in Indian Debt market are likely to de-invest their money from Indian markets.

In June, foreign institutional investors (FII) parachuted out of the debt market, withdrawing $5.6 billion. This was the highest ever withdrawal in the market’s history.

Source: Google (Investopedia)

Source: Google (Investopedia)

Impact on Indian Rupee• Considering that FII’s were selling in Debt Market. • Will they be able to take back INR to U.S.A?• Answer to it will be ‘No’

• After selling in the debt market they will buy USD and sell INR• Buying USD increased its demand and hence appreciating• Selling INR increased its supply and hence depreciating• INR hit an all time Low (Depreciating)

Date: 20 June 2013Open: 58.720Low: 58.720High: 59.977Close: 59.575

Source: Google (Investopedia)

Impact on Equity Market• Lets understand with the help of an example• Consider FII Buying 1 share of BSE SENSEX on 15th April 2013• 1 share at INR 18,771.00 (FX Rate: 54.795). Net worth: $342.57• As of 20 June 2013 BSE SENSEX high is at INR 19,069.20• Question: Did FII made profit or loss within this trade?

Assumption: Trades were executed when markets were on the higher side with No broker charges

Answer: Loss

FII selling BSE SENSEX on 20 June 2013 at INR 19,069.20 (FX Rate: 59.977) Net worth: $317.94.

Because of FX movements, FII’s started pulling out money from Equity and hence closing @ 349.91 points down.

15th April 2013High: 18,771.00

20th June 2013High: 19,069.20

20th June 2013High: 59.977

Thank You!