US Fed tapering and its impact

To understand tapering, we need to know what is Quantitative Easing or QE.

Quantitative Easing (QE):

Quantitative easing (QE), involves the Central Bank of a country buying fixed-income
securities in the open market, in order to infuse liquidity and bring down interest rates,
to stimulate the economy. The Fed has enacted three different rounds of QE since the
2008 financial crisis. In the most recent iteration, it purchased $85 billion of fixedincome securities every month - $40 billion of mortgage backed securities and $45
billion of U.S. Treasuries through till end December 2013.
Beginning January 2014, the Fed began to taper the policy in increments of $10 billion.

The Feds Current Policy-Sep. 2014:

The Feds bond buying program currently stands at $25 billion, and after the latest
meeting, it will go down further to $15 billion.
They have also clearly indicated that subsequent rate actions would be data dependent.
i.e. if the economy improves (focus on employment), rates will head higher. When
remains the million dollar question.
Analysts are expecting that Fed may start to raise interest rates from mid 2015. US
unemployment rate has fallen from a peak of 10% to 6.1% currently.

Impact of Tapering and Rate Hike:

The direct impact will be the US 10 year benchmark government bond yield , currently
at a level of 2.5 percent, to go up to a level of 3-3.5 percent. This will make large
investors like pension funds, insurance companies to invest more in US sovereign
bonds, instead of investing in risky assets. There could be a selloff in global equity
markets, and liquidity will go back home (USA).
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Secondly, when liquidity starts to flow toward US bonds, then the dollar will appreciate
against all the major currencies, a trend already evident today.

Dollar Index Chart

We can see in the above dollar index chart that the dollar has appreciated from a level
of 80 to 85.64 in last 1 year. This is happening when Fed has only done tapering; still
they have not increased the rates. When rates will go up in next year then we can
expect further appreciation of the dollar against all major currencies.

The FLIP side:

Commodity prices (incl. oil) will remain subdued (as they are denominated in dollars)
due to the strength of the dollar. This will benefit countries like India.
The European central bank (ECB) and Bank of Japan (BOJ) are still maintaining an
expansionary monetary policy, and China has also begun its version of QE. So the
question is is the fear overdone? The system as a whole should still remain flush
with funds, thanks to BOJ and ECB.

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