Fed plan to prune balance sheet: impact on equity markets and FPI flows

Following the release of the minutes of the FOMC meeting on Wednesday, the benchmark Sensex at BSE fell 575 points or 0.97 per cent on Thursday, as FPIs pulled out a net of Rs 5,009 crore from Indian equities.

Bond holdings

With elevated inflation and tight labour market conditions, participants at the FOMC meeting agreed on reducing the size of its balance sheet beginning the next policy meeting in May. They called for a faster pace of decline in securities holdings than in 2017-19, when it hit a peak of $50 billion a month.

The participants agreed that “monthly caps of about $60 billion for Treasury securities and about $35 billion for agency MBS (mortgage-backed securities) would likely be appropriate”. According to the minutes, “participants also generally agreed that the caps could be phased in over a period of three months or modestly longer if market conditions warrant.”

This means they can go for a reduction in the balance sheet by up to $95 billion a month.

At the March meeting, the participants had agreed “they had made substantial progress on the plan and that the Committee was well placed to begin the process of reducing the size of the balance sheet as early as after the conclusion of its upcoming meeting in May”.

Fed balance sheet

The Federal Reserve balance sheet that stood at $4.1 trillion on February 24, 2020, rose to $7.3 trillion by the end of December that year, and currently stands at $8.9 trillion — it has more than doubled over the last two years.

The increase in the Fed’s assets was the result of large-scale purchase of assets from March 2020, when the world economy was hit by the Covid-19 pandemic. As the Fed moved to support the economy, it provided liquidity by purchasing assets and extending loans to banks. The credit helped the economy and supported the financial markets.

Balance sheet reduction

The reduction in the balance sheet means that while the Fed will not buy securities from the banking system, it will also not reinvest in the securities that mature. It could also go for a sale of securities on its balance sheet later.

According to the minutes of the meeting, participants agreed that after undertaking the balance sheet runoff (not reinvesting in maturing securities), the Fed can consider sales of mortgage-backed securities. “Committee decision to implement a program of agency MBS sales would be announced well in advance.”

Experts say this would lead to a reduction in the availability of liquidity. “There will be less liquidity in the system and less investible funds available for investments with FPIs. So the flows to the emerging markets could reduce going forward,” Madan Sabnavis, chief economist, Bank of Baroda, said.

Impact on equity markets

If the infusion of liquidity over the last two years pushed the stock markets to new highs, the withdrawal of liquidity too will have repercussions, albeit limited as it will be calibrated. Thursday’s fall in the Sensex followed news that the Fed would start reducing its balance sheet at the pace of up to $95 billion per month. The Nikkei fell 1.7%, Hang Seng 1.2% and Shanghai Composite 1.4%.

Experts say that while the reduction in liquidity will reduce the availability of funds to be invested in emerging markets, an increase in interest rates by the Fed will lead to outflows from domestic equity markets.

FPI flows

In line with Fed announcements over the last few months — first on the increase in interest rate and then on the reduction in the size of the balance sheet — FPIs have been pulling out of Indian markets. Between January and March , FPIs pulled a net of Rs 110,018 crore from Indian equities. Initial concerns on account of inflation and rate hikes in the US were aggravated by the war in Ukraine.

Net outflows in January were Rs 33,303 crore, which increased to Rs 35,592 crore and Rs 41,123 crore in February and March respectively. The March figure was the highest in a month since the outflow of Rs 61,973 crore seen in March 2020, when India announced the Covid-19 lockdown.

However, fund outflows have slowed over the last 20 days, and experts say that the FPIs that had to pull out on account of the Fed’s anticipated move have done so already — and that there is less likelihood of string outflows going forward. Over four trading sessions in April, FPIs have invested a net of Rs 12,202 crore in Indian equities.

In the meantime, domestic institutional investors, led by string inflows from retail investors, have enhanced their flows into the markets. While FPIs pulled out a net of Rs 76,715 crore in February and March, DIIs invested a net of Rs 81,761 crore in the same period, more than making up for the FPI pullouts.

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