Taper Tantrum: Everything You Need to Know

If you are somewhere connected to the financial industry, you must have gone through this term taper tantrum, haven’t you? You are at the right place to find out everything about taper tantrums. Let’s dive in and decipher this topic.

But to understand this term, we need to understand the history of this term as well as what tapering is?

How Central Bank control Currency?

A central bank is a financial organization that has exclusive power over the creation and distribution of money and credit for a country or set of countries. The central bank is normally in charge of formulating monetary policy and regulating member banks in contemporary economies.

According to the Reserve Bank of India Act, 1934, the Department of Currency Management is responsible for managing currency management responsibilities, which are a basic function of the Reserve Bank. Currency management is primarily concerned with the issuance of notes and coins, as well as the removal of unsuitable notes from circulation.

The rupee's value can also be influenced by the central bank's monetary policies. To keep the rupee under control, the RBI can adjust the repo rate (the rate at which it gives loans to banks) and the statutory liquidity ratio (the percentage of net time and demand liabilities that banks must put in liquid assets).

What is Tapering?

Tapering is a term used to describe measures that alter standard central bank operations. Interest rates and market estimates of future interest rate direction are the primary targets of tapering attempts. Changes in the discount rate or reserve requirements might be a part of the tapering strategy.

Tapering may also imply a slowdown of asset purchases, which possibly results in a central bank's quantitative easing (QE) programs being reversed. After QE measures have had the desired impact of boosting and stabilizing the economy, tapering is implemented.

Now let’s understand what quantitative easing is! When a central bank buys long-term securities from the open market or member banks, in order to increase money supply in the economy, it is known as quantitative easing (QE). The central bank injects fresh money into the economy by purchasing these assets; as a consequence of the influx, interest rates decrease, making it simpler for consumers to borrow. 

When the Reserve bank of India buys securities from its member banks, in return, it pays them in cash for assets like bonds. The surplus funds can then be used to lend to others.

The RBI also sets the reserve requirement for banks, which is the percentage of their cash they must maintain in hand against what they lend out. Lowering the reserve allows banks to give out more money. Money supply expands when more money is sent out, allowing interest rates to decline. Lower interest rates encourage consumers to borrow and spend, boosting the economy.

What is Taper Tantrum?

Tapering isn't necessarily a new phenomenon. Taper Tantrum, on the other hand, swept the globe by storm the first time it happened in an awakened and digitally improved period—2013. The term 'tantrum' was coined when investors and stakeholders reacted angrily to the government's announcement that the quantitative easing programme would be tapered.

The term "taper tantrum" refers to a jump in U.S. Treasury rates in 2013 as a response to the Federal Reserve's (Fed) announcement of future quantitative easing tapering. The Federal Reserve declared that it will slow down its Treasury bond purchases in order to lower the amount of money it was pumping into the economy. The subsequent surge in bond yields resulting from the news was dubbed a taper tantrum in the financial press.

The stock market's reaction to the taper tantrum in 2013 was just temporary. The markets were overpriced at that moment, and investors were concerned that the yield surge would set off a lengthy market decline. 

An increase in bond yields maybe beneficial to investors in modest savings plans. The GOI Floating Rate Bonds have rates tied to government bond yields and are adjusted on a regular basis. Those who own debt mutual funds (particularly long-term ones) and listed bonds, may have to brace themselves for additional mark-to-market losses if rates continue to rise.

How does the Central Bank achieve Tapering?

Central banks have a variety of growth-enhancing measures at their disposal, and they must align short-term economic developments to longer-term market expectations. If the central bank reduces its activities too quickly, the economy may enter a recession. If it does not curtail its activities, an unwelcome rise in inflation may be on the way.

By being transparent with investors about future banking activity, it helps to create market expectations. That's why, rather than stopping abruptly, central banks usually unwind their loose monetary policies gradually. 

By stating their tapering approach and identifying the parameters under which tapering will begin or conclude, central banks can reduce market volatility. Any projected cutbacks are discussed in advance with this regard, allowing the market to start making adjustments before the action takes place.

Effects of Tapering on the Stock Market

Investors feared a stock market massacre following the tapering in 2013. However, the impact was mitigated and, mercifully, short-lived. Bond yields and interest rates began to rise when tapering began in the United States. The stock market in the United States performed admirably, whereas the impact on Indian markets was trivial. The Sensex increased by 105 percent between 2013 and January 2020 (just before the pandemic).

Because the values of financial assets—particularly debt instruments such as bonds, but also stocks—are inversely tied to interest rates, critics of QE fear asset price bubbles. Low borrowing rates and low returns on financial assets may have fueled speculative bubbles in hard assets such as real estate. Similarly, an increase in the flow of cash into cryptocurrencies might result from QE. If tapering truly raises interest rates, it might burst speculative bubbles fueled by historically low-interest rates. 

Why is it essential to understand the Taper Tantrum?

When US Treasury rates spiked in 2013, it precipitated a multi-month exodus of money from developing market economies, which began in May of that year. Between May 22 and August 30, 2013, the rupee lost almost 15% of its value. To stop the withdrawals, the RBI had to hike interest rates unexpectedly.

Investors have less motivation to invest in riskier assets such as stocks when rates on ultra-safe US bonds climb. 

The Bottom Line

Hope now you are clear with this topic. Do let us know in the comment section if you have any such topic that needs an in-depth explanation.
Happy reading!