Since few months when you watch some business news channels, you notice the few common words they are mentioning-strength of dollar against rupee, bond yield raising, USA strong economy, FIIs outflow or USA Federal Reserve meeting. What effect all these have on retail investors like you and me? What all these terminologies meant to me as a common mutual fund investor? Let us understand all these in a layman perspective.
This post may be bigger than my normal posts. But it includes everything in detail in a simplified manner. To begin our journey, first let us look at a higher interest rate is good or lower interest when we look at whole economy perspective? When the economy is looming under higher interest rate era, banks will also lend with higher interest rates. So borrower such as companies or businessmen will feel the heat of high interest rate for their investments and business. This leads to higher productivity cost and increasing the rate of the product and service they offer. For us also when the interest rate on any loan is high then we may postpone our decision of buying a home, car or any other accessories. This low buying will lead to lower economic growth. At the same time when interest rate starts to fall then banks will start to lend at lower rates which automatically makes easy and cheaper fund for industries and businessmen. It also grows the some industries like real estate as we start to look at buying home when loan we take will have lower EMI.
The second thing I need to clear here is what our news channels buzz word “high bond yield”. Let us say ABC company offered a bond with a face value of Rs.1, 000 and a coupon rate of yearly Rs.80 (means 8%). Next year due to raise in interest rate of the market (meant to say your bank is offering around 8.5%) another company named XYZ offering the Rs.1,000 face value bond at coupon rate of Rs.85 yearly (8.5%). So which one you buy? ABC Company or XYZ Company? Obviously XYZ Company bond. So no one will be there to buy ABC Company bond. But for ABC Company bond to sell in market it have two options-One is to higher the coupon rate, which they can’t do as it is fixed. Second is to sell at lower than the face value (Rs.1,000). So they sell at Rs.940 to equal the return from this bond to Company B’s bond. Now the return from Company A’s bond raised. But how? If you are a new buyer from Company A then you need to invest Rs.940 only but you are getting return of Rs.80 as a coupon throughout the period. So return on investment raised to 8.5%. This is what is happening now in the market. High interest rate led to fall of bond price and raise of bond yield. I hope you understood the concept.
Now let us move our topic towards the USA, a big boss who maintains the world economy indirectly. We all know everybody start to concern about USA’s central bank called Federal Reserve (it is like our RBI to India) meeting. What is this meeting all about and what do you mean by QE3 or Quantitative Easing-3?
Quantitative Easing is the one such process where by central bank (like our RBI) try to maintain lower interest rate so that economy will grow. We already discussed the effect of lower interest on economy. But why USA Fed is following this method instead of lowering interest rate like what our RBI does? It can’t do so, because interest rates are already at a lower rate. Hence normal process lowering of interest rate will not work out. So what they will do? Below are the steps what the USA Fed started to lower the interest rate.
1) USA Fed with the approval of Govt starts to print a lot of currency notes.
2) From these currency notes it starts to buy bonds or other financial instruments from financial firms such as banks, insurance companies and pension funds.
3) Companies which sold bonds to Fed will have plenty of cash. They can’t invest that cash again into bond as it seems costly. So they start to offer loans to companies or individuals at lower rates.
4) If more lenders with plenty of money targeting the limited consumers will automatically lead to lower interest rate. This leads to growth of economy.
5) Once the economy recovers USA Fed will sell the bonds what it holds during the period of QE long back to from whom it bought. Cash it received will be destroyed as it is created only to boost the economy (in theory).
On September 2012 USA Fed announced its third round of quantitative easing which is called QE3(QE1 was started from November 2008 to June 2010 and QE2 was started from November 2010 to June 2011). During its announcement Fed declared that this move will be extended till 2015 showing the USA economy still not developed. This plan announced buying $85 billion of fixed-income securities per month, $40 billion of mortgage-backed securities and $45 billion of U.S. Treasuries. Even though this time it started with a long term perspective but after the USA economy recovery it is slated that they will wind up this within 2013. This is the concern what is impacting our equity market.
Let us see now what this QE3 impacted on the USA stock market. As the economy started to grow and the stock market started to boom with no opportunity for FIIs (Foreign Institutional Investors) to invest in that market. So they started to look at emerging markets such as India. This move picked up Indian stock market. On June 19, 2013, FED announced a “tapering” of some of its QE measures stating that it would scale back its bond purchases from $85 billion to $65 billion a month during the upcoming September 2013 policy meeting.
This news actually was the shocking to the Indian market as FIIs started to withdraw. This is why dollar started to appreciate against the rupee and equity market started to tumble. It is exactly opposite to what happened when the start of QE3. Major movers and shaker of Indian bond as well as equity markets are these FIIs. So if they started to move then automatically it will be a negative impact on India.
So what we can understand is, never think FIIs as investor of stock or bond market. They will invest, book profit and vanish whenever they feel. Hence the real value of our market will be market-FIIs=Real market value. I don’t to what level this jerk will bring the market but it certainly give a good example of how we need to analyze the things before investing in market. Hope this post simplified the current down trend in bond as well as equity market.