The Indian stock market has been nervous for the past week or so… and for good reason.
The main reason why the markets have risen so much since March 2020 has been the easy money flowing into them.
This easy money was created and supplied by central banks around the world, led by the main central bank, the US Federal Reserve.
As long as interest rates remained low and the liquidity tap remained open, financial markets around the world rose.
Investors and traders were not worried about a massive crash despite Covid, knowing the flow of easy money would continue. For example, ‘buy the dip’ was the theme that drove the markets.
The reason for the recent decline in the market is the tendency of the US Fed to reverse this policy.
In recent months, the Fed has expressed its intention to end the era of easy money. They do this by raising interest rates and taking the money they had made available from the market.
In the markets this is called ‘tapering’ or ‘the taper’.
Many central banks around the world have already raised interest rates, the most prominent of which is the Bank of England.
At a two-day meeting on January 25-26, the US Fed will make a decision on interest rates and liquidity withdrawals.
The markets are not necessarily concerned about the announcement itself. They know it is inevitable.
The cause for concern is the pace of these movements.
Markets fear a rapid reversal of the easy money policy. To be specific, the concern is about how soon the Fed will raise interest rates and the date it wants to completely reverse the supply of all the money, i.e. the stimulus it has given since 2020.
All other central banks will follow their instructions from the Fed. If the Fed announces an aggressive policy reversal, markets will assume all other major economies will do the same.
This would mean a sharp rise in interest rates worldwide and a lot of pressure on asset prices, including equities.
The Indian market will be closed tomorrow due to Republic Day. So they will respond on Thursday, January 27. The Fed is said to have announced its policy before the Indian market opens, either late Wednesday or early Thursday.
So how will the market react?
Well, there are a few possibilities…
First, there is the main question about interest rates.
The US market does not expect the Fed to raise interest rates during this meeting. Instead, it expects the first increase at its next meeting in March 2022.
At this meeting, the US market expects the Fed to announce the start of the rate hike cycle in March and also provide a timeline for future rate hikes.
Investors and traders are very interested in two things: both the magnitude of the rises and the duration. They want to know whether the Fed will raise interest rates in 0.25% or 0.5% increments. And how long will the Fed keep raising rates? 2023? 2024? Longer?
Then there is the massive amount of money the Fed has printed and delivered to the markets. How is it revoked? And how fast?
The Indian market, as well as all other stock markets around the world, are nervous about these questions. If the US market were to react negatively to an announcement, there will be a similar reaction in every other country.
For example, the Fed could decide to raise interest rates at this meeting. It could indicate an aggressive policy of rate hikes, say 0.5% at every meeting this year. The market expects only 4 rate hikes this year. If the Fed announces more, the markets will react badly.
FIIs will sell aggressively in such a situation.
On the issue of liquidity withdrawal, the market is not expecting anything aggressive from the Fed. She expects the Fed to announce the start of this process in the second half of the year. Some on Wall Street think the Fed could delay its liquidity withdrawal until the end of the year.
What if the Fed doesn’t oblige and instead announces a plan for a quick withdrawal of easy money?
Well, then you can expect a sharp fall in the stock market on Thursday.
In the financial markets they say, ‘If the US sneezes, the world will catch a cold’. This has been true for a long time. There is no reason to expect that the situation will be different this time.
But what about the long term?
Will the Fed’s move change the course of the market? Will the bull market be replaced by a bear market? Will we see a crash like in 2020?
These are legitimate concerns, but long-term investors can rest assured that they will not need to change their investment strategy.
As long as you’ve bought high quality stocks with a good margin of safety, the stock will do well in the long run.
If either one is missing, quality fundamentals or margins of safety, the liquidity reversal will take its toll on these stocks. Low-quality stocks and stocks that offer no margin of safety could see significant declines.
We recommend taking a good look at your portfolio to separate the weeds from the flowers.
Rest assured, Equitymaster’s editors will contact you in the event of a sharp drop in the market.
Disclaimer: This article is for informational purposes only. It is not a stock recommendation and should not be treated as such.
(This article is from Equitymaster.com)
(This story was not edited by DailyExpertNews staff and was generated automatically from a syndicated feed.)