When can FIIs return? Fed’s previous tightening cycle drops some clues

Taper is behind, but tightening is ahead. That is a subtle one-liner that captures what to expect from Fed going forward. On taper, US Fed stuck to its schedule. It began the program in early Jan and quickly finished it by winding down new bond purchases to zero by end of March’22. Now it is onto the next, rate-hikes and balance sheet shrinking. With monetary tightening in terms of balance-sheet reduction, expected to begin by Jul-Aug, it will not be out of place to peep into what happened in the previous stimulus cycle to get a sense of what lies ahead. Looking back, in the earlier Fed stimulus cycle (post Global Financial Crisis), though taper started in 2013, it wasn’t until late 2017 that the Fed really started taking serious steps to shrink its balance sheet. For the uninitiated, taper refers to winding down the size of the fresh bond purchases while balance sheet reduction refers to allowing those earlier purchased bonds to mature without repurchases. As is well known, the later has a much bigger impact on the market as the excess stimulus liquidity is pulled out of the markets by allowing the bonds to mature without repurchases. That’s how Fed scales down its balance sheet size after every stimulus cycle.

This time too, Fed has an ambitious plan to arm down its pandemic stimulus by planning to shrink its balance sheet by a sizable scale in the coming months. As per some estimates, it may, in all likelihood, start with 25Bn dollars a month from Jul-Aug, slowly accelerate to 95Bn and end the entire unwinding by 2023 December. If that happens, one is talking about taking out over 1.7tn+ dollars of liquidity out of the system in 18/19 months beginning July/Aug. To put that in perspective, it will be nearly thrice the amount that was pulled out in the previous cycle in 2018/19 i.e. about 660Bn dollars were pulled out as part of balance sheet reduction program from Feb’2018 and Aug’ 2019. 

By any scale, this is a massive unwinding. The world had not witnessed such a large-scale winding-down any time in the past. Of course, relative to what was pumped during pandemic (near 5 trillion dollars from April’20 to Mar’22), the scale of unwinding may not seem sensational. Given that the Fed’s balance sheet expanded from 4 trillion to near 9 trillion dollars in this period, a gradual reduction over the extended period is probably the best outcome one could hope for. Yet, markets are naturally worried whether FIIs will ever come back to emerging markets in this period when Fed is busy pruning its balance sheet. Given this huge overhang of liquidity challenge for the foreseeable time, it may seem realistic to assume that FIIs are unlikely to return any time soon, esp. after their massive exodus from India since Oct’21. For the record, they have pulled out over 23 billion dollars (net sales) since then.

It is precisely here, where a peep into the past liquidity cycle could throw some interesting insights into how FIIs behaved in a similar situation. Let us go back and look at the period between Jan’18 and Aug’19. In this period, Fed reduced its balance sheet by over 660bn dollars, by pulling out an average of 30bn dollars every month (exact amount varied from low of 16bn to as high as 61bn in different months). It helps further to split this period into two to understand how FIIs behavior changed over the time of the unwinding. In the initial part, as the Fed unwinding started, FIIs started pulling out in Feb’18 and accelerated their pace during the mid-year to reach the peak sometime in Oct-Nov’18. FIIs pulled out over 6.5bn dollars in this period. But, what happened post that was more interesting. Until this period, Fed’s unwinding was about 30Bn dollars per month, which it later increased it to 38Bn dollars per month from Jan’19 until Aug’19. Ironically, after the increased quantum of monthly unwinding from Fed, FII flows reversed into inflows and there was a massive net inflows of over 13bn dollars in the period between Jan’19 and Aug’19. Not to forget that in this period, over 300bn dollars was pulled out by Fed to reduce its balance sheet. So, what does one conclude from this?  Is there a co-relation between Fed’s unwinding and FII flows?  Of course, there is co-relation in the initial period, but not long after. More importantly, what is more interesting is that the inflows in the later part were twice the money that left in the initial part. Having said this, it is also important to keep in mind that no two cycles will be same. While the broad pattern may be similar, exact point at which the tide will change for FII flows could be difficult to predict. But what is more important to understand is that the FII money will come back much sooner than Fed’s timeline for unwinding. Not only it will be sooner, but it will be much larger than what went out. This is one reason why some seasoned investors are expecting a melt-up (bull- run) for Indian markets next year (2023). From this perspective, the current weakness, which is likely to continue for few months on account of Fed’s rate-hike and balance-sheet-shrinking overhang, is a great opportunity for long-term investors to lap up their positions, esp. on those sporadic panic days which will come often for a while.

Happy Value Investing!!!

This article of mine was published in the online edition of Economic Times (03/05/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/when-can-fiis-return-feds-previous-tightening-cycle-drops-some-clues/articleshow/91284603.cms