All You Need to Know About Tapering

The term "taper tantrum" refers to the financial markets' main response to the idea or reality of a central bank, specifically the U.S. Federal Reserve, reducing quantitative easing (QE) business operations. 

This typically involves quick outflows from developing markets, rapid interest rate rises, and market fluctuations.  It started in the summer of 2013.  It occurred following Chairman of the Federal Reserve Ben Bernanke's signal that the Fed would start to minimise, or taper, its quantitative easing policy.  In the 2008 financial crisis, this meant making large purchases of government bonds to support the economy.

You are on the right page if you are looking for an answer to what is tapering.

Background of the Taper Tantrum

The "Taper Tantrum" symbolises the immediate response of the financial markets to Federal Reserve Chair Ben Bernanke's expression from May 2013. Before knowing what is tapering, let’s examine its background.

Post-Credit Crisis Period (2008–2013)

The Federal Reserve (Fed) utilised unusual policy measures in an attempt to stabilise the economy after the global financial crisis of 2008.  One of these was quantitative easing, an effort in which the central bank buys securities on the open market, including government-issued ones, to increase the money supply and encourage lending and investment.

Scientific Relief

From 2008 to 2013, the Federal Reserve carried out three rounds of quantitative easing (QE1, QE2, and QE3). Apart from lowering interest rates to promote economic expansion, these actions resulted in a significant influx of new capital into the financial sector.

The May 2013 "Taper" Notice

In May 2013, Bernanke made a suggestion that the Federal Reserve might start to "taper" its asset purchases if the economy started to improve. This surprised many investors because they were used to the Fed's quantitative easing strategy. 

The market's response is known as the "Tantrum"

The market's expectation that cheap money would run out led to a sharp increase in U.S. Treasury rates on the belief that the Fed would reduce its level of support. And it was the "tantrum."

 The markets applied the term "Taper Tantrum" to describe this unexpected response.  These actions injected significant new money into the financial system and helped keep interest rates low to support economic expansion.

Global Effects

Affected areas also included emerging economies, many profited from the QE era's yield chase. Significant capital outflows and currency devaluations sent money back to the U.S.

Experience gained

The Fed and other central banks learned essential lessons from the Taper Tantrum on communication and the effects of adjusting monetary policy following a protracted easing period. This experience has shaped how such transitions are managed to reduce market disruptions.

Taper Tantrum: Factors Affecting 

Now that you know taper tantrum meaning, let’s understand the factors affecting it.

• Investor Expectations

The Taper Tantrum was largely caused by investor expectations. Many investors used to the low-interest rate environment were taken aback when the Fed announced it would reduce its quantitative easing program. 

Bond markets saw a sell-off and a move away from riskier assets due to the possibility of decreased liquidity and rising interest rates.

•  Conversation and Proactive Help 

The significance of forward guidance and communication in monetary policy was emphasised by the Taper Tantrum. The abrupt announcement of QE reduction without precise time or tempo instructions confused the financial markets. 

This experience showed how important it is for central banks to openly and adequately explain their policy goals to prevent erratic market reactions.

•  Market Stability

Another reason for the taper tantrum was market liquidity or the ease with which assets may be purchased or sold without impacting their price. Concerns about decreased bond market liquidity, which would raise rates and cause volatility, were heightened by the possibility that the Fed may cut back on its bond purchases.

Effects of the Taper Tantrum 

• Bond Offered Consequences

The Taper Tantrum's significant effect was the rise in bond yields, particularly those of U.S. Treasury bonds.

This sharp yield increase reflected investor excitement of rising interest rates and less bond market liquidity. Bondholders suffered financial losses due to increased rates as rising yields caused bond prices to decline.

• Impact on Developing Markets

The Taper Tantrum had a special effect on emerging markets. Emerging markets saw capital flight in response to the possibility of stricter monetary policy in the US, which pushed their interest rates higher and their currencies down. These economies had difficulties, which raised the cost of borrowing money and raised inflation.

• Importance to Monetary Policy

Monetary policy was significantly impacted by the Taper Tantrum. It underlined the need for open and honest communication in managing investor expectations.

It also emphasised how major central banks' choices on monetary policy had an impact on the whole world, highlighting the importance of rigorous coordination and communication on a global scale.

What Effect Did India See? 

The low U.S. mortgage rates during the QE time satisfied borrowers but worried banks.  Even though there was more money to be given, lenders were worried about the low-interest rates. Utilising the extra stimulation that was launched into the banking sector was essential. 

During that time, US investors began flooding Asian markets with cash, particularly towards developing countries like India. International investments in India increased as a result.

However, American investors in India started to sell their assets when the U.S. Federal Reserve decreased as American interest rates began to rise and offered them a higher return on their investment. Retention by foreign investors causes a sharp reduction in the value of the Rupee.  This pushes the RBI to raise interest rates overnight. The increasing value of the US currency is causing inflation in India to rise. 

This led to the Taper Tantrum event, almost bringing down developing economies due to investor exaggeration. Rising prices significantly affected India, and other developing countries such as Indonesia, Brazil, and Turkey also suffered, with the suffering compounded by the depreciation of their currencies against the US dollar. 

Despite investors' fears that this would spark a worldwide panic, fortunately, that nightmare did not come true then. But it doesn't mean the markets didn't respond.

Benefits For Central Banks From The Taper Tantrum

Central banks learned important lessons during the Taper Tantrum. It showed how important it is for monetary policy to communicate straightforwardly and in a in forward-looking.

Central banks may control investor expectations and lessen the chance of sudden market reactions by giving markets clear indications about their policy goals.

Additionally, it highlighted how major central banks' policy decisions impacted the whole world, emphasising the necessity of international coordination and collaboration in monetary policy.

Investors

The Taper Tantrum imparted insightful insights to investors as well. It warned about the dangers of sudden adjustments to monetary policy, especially in an international financial system where decisions made in one nation might significantly affect another. The significance of portfolio variety for reducing risks and enduring market volatility was emphasised to investors.

Investors were reminded of the importance of portfolio diversification to mitigate risks and weather market volatility.

Policy Makers

Policymakers learned valuable lessons from the Taper Tantrum as well. It demonstrated how monetary policy decisions might affect economic stability, especially in developing economies.

The Taper Tantrum clarified how important it is for decision-makers to carefully monitor the financial and economic landscape and prepare for unexpected market shocks.

Conclusion

A "taper tantrum" is the market upheaval that followed the Federal Reserve's 2013 announcement that it would be scaling back its quantitative easing program. This incident highlighted the need for clear direction and efficient communication in monetary policy, international policy coordination, and their worldwide effects. 

It affected economies and financial markets worldwide, particularly in emerging nations, and raised bond rates, market volatility, and capital outflows. The occasion taught essential lessons about portfolio diversification, emergency preparedness, and clear communication in monetary policy. 

Understanding the complexities of the global financial markets is essential for good asset management. One may better manage market volatility and ensure one's financial future by keeping up with economic developments and policy changes and diversifying their investment portfolio