The taper is behind, but the tightening is ahead. This is a subtle one-liner that captures what to expect US Federal Reserve going forward.

on taper, US Fed Stick to your schedule. It launched the program in early January and quickly ended it by closing new bond purchases to zero by the end of March 2022. Now, it’s headed for rate hikes and balance sheet shrinking. with monetary tightening In the context of the balance sheet reduction expected to start by July-August, to understand what happened in the previous stimulus cycle, it would not be out of place to see what lies ahead.

In the last Fed stimulus cycle (after the global financial crisis), although it began to taper in 2013, it was not until late 2017 that the Fed really began to take serious steps to shrink its balance sheet. For the uninitiated, a taper refers to reducing the size of new bond purchases, while a reduction in the balance sheet means allowing those previously purchased bonds to mature without repurchases. As is well known, the latter has a huge impact on the market as additional incentive liquidity is extracted by allowing bonds to mature without repurchases. Similarly, the Fed reduces the size of its balance sheet after each stimulus cycle.

This time too, the Fed has an ambitious plan to reduce its pandemic stimulus by planning to massively shrink its balance sheet in the coming months. By some estimates, this is likely to start at $25 billion a month from July-August, and gradually increase to $95 billion to end the complete unwinding by December 2023.

If that happens, one is talking about taking out more than $1.7 trillion of liquidity from the system in 18-19 months. To put this in perspective, this would be almost three times of the $660 billion that was pulled out in the previous cycle in 2018-19.

On any scale, it is a massive opening. The world had never seen liquidation on such a large scale before. Of course, the scale of the unwinding relative to what was pumped in during the pandemic (close to $5 trillion) may not sound sensational. Given that the Fed’s balance sheet grew from $4 trillion to close to $9 trillion during the pandemic, a gradual reduction over an extended period is probably the best outcome one can hope for. Nevertheless, markets are naturally concerned about whether FII Emerging markets will return anytime during this period. Given this huge overhang of liquidity challenges for the foreseeable future, it may seem realistic to assume that FIIs are unlikely to return any time soon, especially after their massive exodus from India in October 2021. For the record, they have withdrawn over $23 billion. (net sales) since then.

This is precisely where a peek into the past liquidity cycle can yield some interesting insights into how FIIs behaved in a similar situation. Let us go back and look at the period between January 2018 and August 2019. Over this period, the Fed slashed its balance sheet by more than $660 billion, taking out an average of $30 billion each month (the exact amount varied from a low of $116 billion to $61 billion in different months).

It helps to divide this period into two parts to understand how FII behavior changed over the time of unwinding. In the early part, as Fed unwinding began, FIIs started exiting in February 2018 and accelerated their momentum during the mid-year to peak sometime in October-November 2018. They withdrew over $6.5 billion in this period. But, what happened after that was more interesting. By this period, the Fed’s unwinding was about $30 billion a month, which later increased to $38 billion a month from January to August 2019. Ironically, following the increased amount of monthly unwinding from the Fed, FII inflows reversed and had massive net inflows of over $13 billion over that period. Let’s not forget that in this period, the Fed pulled out more than $300 billion to shrink its balance sheet.

So, what does one conclude from this? Is there a correlation between Fed’s unwinding and FII inflows? Of course, there is correlation in the initial period, but not long after. More importantly, what is more interesting is that the inflow in the later part was twice the outflow in the early part. Having said this, it is also important to keep in mind that no two cycles will be the same. While the broad pattern may be similar, the exact point at which the tide will turn for FII flows can be difficult to predict. But it is more important to understand that FII money will come back much quicker than the Fed’s timeline for unwinding. Not only will it be quick, but it will be much bigger than what happened. This is one reason why some seasoned investors are anticipating a bull-run for the Indian markets next year (2023).

From this perspective, the current weakness, which is likely to continue for a few months due to the Fed’s rate-hike and balance-sheet-shrinking overhang, is a great opportunity for long-term investors in particular to step up their positions. . Those days of sporadic panic that would often come for a while.

(Arunagiri N is the founder, CEO and fund manager at Trustline Holdings.)