The stock market has been quite volatile in recent weeks. A lot of people are of the opinion that it is due to the newly discovered Omicron variant. But in my previous article, I demonstrated that Omicron was never a concern to Wall Street. So then what was it that really spooked the stock markets? Well, it was the US Fed’s earlier tapering announcement.
If you are an investor, you may have heard “tapering” and “interest rate hike” a lot lately, but few people understand what they mean. I found many of the discussions are at a very superficial level. So in today’s article, I will explain to you:
- What is Fed Tapering and how does it work?
- Why does Tapering matter to the stock market?
- What does China’s crackdown have to do with Fed Tapering?
- What are the risks and opportunities in this environment?
Some of the information may be hard to digest at first glance, so feel free to ask questions by commenting below.
What is Fed Tapering?
The “Fed” refers to the US Federal Reserve, which is the central bank of the United States. Because the US dollar is the most used reserve currency of most central banks around the world, any decision by the Fed will impact most of the financial markets.
When the Fed starts to “taper”, it means that the Fed will withdraw some of its money from circulation, which is “tightening” in layman’s terms. Eventually, Tapering will lead to a higher interest rate.
Why? How are the two actions connected?
We have all heard of the phrase “printing money”, even my children know that from our dinner conversation. But how does the Fed “print” money? The way the money is printed is through an “asset purchase” and this is largely done via a bond purchase. When the Fed buys bonds from the market, they need to pay the bondholders. To pay the bondholders, the Fed literally “prints” money. Thus the money flows from the central bank through the financial system.
Why does Fed Tapering lead to an interest rate hike?
Bond 101 tells us that a bond’s price has an inverse relationship with the interest rate. When the Fed buys more bonds, the bond prices go up and therefore the interest rate goes down.
When the Fed tapers, the reverse happens. The Fed will slow down and eventually stop asset purchases. When less bond buying occurs, the bond price goes down and the interest rate goes up
The Fed began tapering a few years ago. But they reversed course due to the Covid situation and made even more aggressive easing. Now all this will come to an end.
Does the Fed really taper to combat inflation?
Many people say that the Fed tapers to combat rising inflation. However, this is putting the cart before the horse.
People are misguided to believe tapering is a passive reaction to inflation. The truth is, all these actions were planned out a long time ago!
I wrote an article in June 2020 where I explained that inflation is the only way for us to get out of the global pandemic. Here is how I started,
“We were on the verge of the greatest retirement crisis in history and COVID-19 just triggered it. In the decades to come, globally, we will witness hundreds of millions of people slipping into poverty in their retirement years, not because they lost money in the stock market, but because they are savers.”
So it is not a surprise to me when the US set an average inflation target in September 2020. They were laying the groundwork for future tapering.
Additional Reading: 5 ugly truths of the upcoming retirement crisis and how to deal with it.
In fact, “inflating your savings away” is an open secret and everybody somehow knows it. That is why the concept of cryptocurrencies and #defi was so easily accepted and prevailed over a short span of a few years. But I think as long as the world operates with individual government sovereignty, the current financial system cannot be replaced as it will cause global mayhem. However, I believe a parallel system may be able to form as I discussed in the article below.
Additional Readings: What is the metaverse and why you don’t want to miss this investment opportunity.
Let’s come back to inflation.
Conventional wisdom tells you that because the global central banks print money, it therefore, causes inflation. Unfortunately, everybody repeats this without a deep understanding of the subject.
But if you think about it, quantitative easing didn’t start yesterday, but more than a decade ago.
Then why was there no inflation until now?
As I explained in this article, inflation is man-made, it is not natural. You and I cannot decide when inflation happens and how it happens, but the US central bank can. It means everything is under the control of the Fed. They can let inflation happen or let it fade. It is controllable.
Tapering isn’t necessarily bad for the stock market.
Many people say tapering means the end of easy money and the stock market will crash.
Some “experts” even predicted that the dollar system will collapse due to the amount of money printed and that the value of the US dollar will decline to a record level. However, they just repeat what other people say without understanding the fundamentals.
In June 2021, I wrote these words to my clients:
In my opinion, the Dollar will not and cannot collapse anytime soon. It is my wild guess that the US may raise interest rates sooner than they promise. The magnitude of the hike may be small but it is symbolic to kick start the global tapering. This is the scenario which we should prepare as it has a structural impact on the asset prices.
So what did we need to do to prepare?
On contrary to what people believe, the problem was not going to come from a dollar crash or a US stock market crash. Instead, we needed to be careful of a potential avalanche of asset prices from some emerging markets due to the outflow of foreign capital given a rapid currency depreciation.
Therefore, to prepare, we needed to understand that the risk was not from a US market crash. The real risk was from other countries with asset bubbles.
This makes it sound like I’m a doomsayer, but it is already happening. For example, the Turkish Lira lost almost 50% of its value against the dollar this year alone and the country is in misery now.
If you look around, the asset bubbles are everywhere. Even in Singapore, resale condo prices were up for the 16th straight month in November, the longest consecutive rise since 2013.
Additional reading: How does inflation affect your investment returns?
Many people are rushing in to buy real estate this year, little did they know the big money is quietly pulling out of Singapore. Did you know that the Singapore dollar has lost 4% against the US dollar this year!
That also explains why the US stock markets continue to be strong this year while almost all other stock markets are range-bound. The smart money has already anticipated the Fed tapering and they have already been repatriating the money back to the US since the second half of the year.
Why the Fed doesn’t want to taper now but they have to.
For decades, the US has been playing the same financial game to transfer inflation out of the country and bring wealth back through the rise and fall of the dollar, through easing and tightening the monetary policy.
How did they do it?
In order for a country to outsource inflation, there are three conditions that need to be met:
- Rising interest rate – interest is the price of a currency, a higher interest rate will attract money and it will begin flowing to your country.
- Appreciating currency – stronger currency will attract foreign money to buy local assets (think about Singapore real estate) and it also gives you more purchasing power to buy cheaper products from overseas to neutralize the inflation effect.
- Asset bubble in other countries – the country with hot money outflowing will see their asset bubble burst. A country with a strong currency can come in to buy quality assets at much-discounted prices.
It may not be easy to understand so I will just give you the conclusion:
The US has missed the best opportunity to tighten and raise the rate which was the beginning of this year.
Why do I say this?
We need to know that the Fed is not stupid. The smartest people are running the US central bank and they definitely know better than me. They knew inflation was coming and they signalled a few times that they wanted to start tapering.
The problem is, due to the back and forth of the Covid situation, the Fed is forced to “please” the market and politicians to continue with easing monetary policy.
However, this gives China, which has learned its lessons from all the past crises, an opportunity to do just what the USA was supposed to do.
Why did China crash their own stock markets?
China started massive tightening at the end of last year. This was marked by the fated day when Alibaba’s Ant IPO was cancelled. They have voluntarily poked all the bubbles and did massive deleveraging. Examples include the China tech crackdown on the education industry to deleveraging the property developers.
That is why in July, I talked about the structural shift of China’s capital market.
Many people believe China is killing themselves, but they don’t understand the Chinese saying of “置之死地而后生” in Sun Tzu’s “The Art of War”. It means to deploy troops in such a way as to leave no room for manoeuvre nor any route for escape so that the soldiers will fight for their dear lives out of desperation and eventually win the battle.
This may not be a perfect analogy and it could be just my wild guess, but I think China is taking on an unprecedented gamble. And the market seems to buy into the idea.
Remember we just talked about how most currencies, including the Singapore dollar, are depreciating fast against the US dollar. But do you know this has not happened to China’s yuan?
The fact is, the Dollar Index has gone up 7% in the past half a year. But even with the Dollar Appreciation, the RMB has appreciated more than 12% against the US dollar from May last year until now. That is huge for currency movements!
How should we interpret this? Well, it means there is still strong demand for Renminbi dominated assets from an institutional point of view.
Just now, we discussed the final step of outsourcing inflation was to burst asset bubbles. What if there is no big enough asset bubble to burst?
For the US, China was the best target for the size needed. But from the stock market to the property market, China’s asset prices are currently at a bargain.
In fact, with the outbreak of Omicron, China’s domestic stock market rose when every western stock market fell. I think the market treats China assets as safe heaven now.
Let’s put everything together
I covered quite a lot of things today. They seem to be different subjects but the relationships are intertwined.
If you can link them up, a lot of things will start to make sense:
- Why did the Fed flip-flop between dovish and hawkish attitudes towards hiking interest rates?
- Why did Fed Chairman Powell remove the word “transitory” from inflation immediately after he was re-elected?
- Why was China’s stock market little affected during the global “panic selling“?
- If the US stock market crashes one day, will China’s domestic market become a safe haven?
Additional Reading: Why should a foreigner invest in China A-Shares and How?
The financial markets will continue to swing up and down around the themes of inflation, tapering and interest rate movement. I hope my analysis has given you a better perspective of what is happening in the market. Don’t be fooled by the mainstream media.
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