All you need to know about taper tantrum

What Exactly Is a Taper Tantrum?

A financial event referred to as a taper tantrum occurs when a central banker announces their intention to taper (decrease) their asset purchases, which in the United States is primarily done through the actions of the Federal Reserve.

These asset purchases are mainly made in the form of bonds and are designed to support and stabilize the economy during times of crisis by injecting liquidity into the financial system.

When an investor hears that the central bank's backstop may no longer exist, the fear of higher interest rates and reduced monetary support causes them to immediately sell off their commercial paper (a form of security).

As a result of the panic selling of bonds, bond prices decrease and yields increase at a faster rate than debt, making it increasingly more costly to borrow funds for business and consumer purposes. Although the taper tantrum starts in the United States, its impact generally does not remain in the United States.

For some countries, such as India, the repercussions of a taper tantrum may be immediate and profound, causing an increase in inflation, a decline in the value of their currency, a decrease in foreign investment and, depending upon the severity of the taper tantrum, instability in their respective stock markets.

The Crisis That Started It All

The first major taper tantrum stemmed from the financial crisis of 2008. When stock markets were on the verge of collapse and investor confidence had all but disappeared, the US government responded with a highly aggressive form of monetary intervention called Quantitative Easing (QE).

Quantitative easing is where a central bank (in this case, the Federal Reserve) purchases large quantities of bonds, which creates liquidity in the economy by injecting money into the financial system.

Essentially, keeping interest rates close to 0% and therefore promoting borrowing while also indicating to the market that there is a chance of recovery taking place.

The creation of liquidity resulted in a flood of new investment capital from international investors who sought to invest their capital into all major world markets, including developing economies such as India, in search of potentially greater returns on their investments.

Lessons for Investors

The taper tantrum taught an important lesson: the world’s financial system is interconnected. Thus, a policy announcement made in Washington will affect the currency of India, the market of Brazil (São Paulo), and the interest rate of Indonesia.

For India, both the 2013 event, as well as the current situation with tapering fears, is an indication that instead of reacting to short-term volatility in the market, we need to remain focused on long-term economic indicators.

As India’s financial markets matured, the response to subsequent signals related to tapering has tended to demonstrate significantly less instability.