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Stock market plunge: It's the 'operation twist' effect

Given its biggest drop in the last 12 months, the 30-share index was in a free fall with none of the stocks advancing and some of them declining in the range of 6 to 9 per cent on an intra-day basis.

Rajiv Bhuva | September 22, 2011 | Updated 19:22 IST

Rajiv Bhuva
For markets, in the last couple of days, it's flowing anything but good news.

Domestically, what began with the Reserve Bank of India's much anticipated hawkish rate hike and a fuel price hike continued with the International Monetary Fund's world economic outlook forecast. IMF forecasted world growth to be about 4 per cent in 2011 and 2012. This was down from the 4.5 per cent for both years that IMF forecasted in April this year.


"Now, 4 per cent may not sound too bad, but, again, the recovery is very unbalanced," Olivier Blanchard, IMF Economic Counsellor and Director of Research Department said during a briefing on September 20. In his briefing, Blanchard quoted Christine Lagarde, Managing Director of the International Monetary Fund, who on Tuesday said that the global economy had entered a dangerous new phase.

The recovery has weakened considerably, and downside risks have increased sharply. Strong policies are needed both to improve the outlook and to reduce risks.

And while that bad news was still getting factored into the markets, the US Federal Reserve's Federal Open Market Committee, or FOMC, concluded its two day policy meeting, where the committee commented that 'there are significant downside risks to the economic outlook, including strains in global financial markets.'

Fed pessimism hits investor confidence, Sensex plunges 704 points

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the FOMC decided to extend the average maturity of its holdings of securities.

"The committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative," the FOMC statement said.

Amidst all this, 'significant downside risks to the economic outlook' in the US have brought global markets into jeopardy.

Along with global indices, oil prices sank below the $85 a barrel mark. Associated Press reported that Benchmark oil for November delivery was down $1.35 at $84.57 at midday Singapore time in electronic trading on the New York Mercantile Exchange. Given that oil traders look upon stock markets as a barometer of overall investor sentiment, plunging global equities weighed on oil prices.

In the domestic market, mirroring the global sell-off, the BSE Sensex at one point plunged by 749 points, or 4.4 per cent, to touch 16,316.03. Given its biggest drop in the last 12 months, the 30 share index was in a free fall with none of the stocks advancing and some of them declining in the range of 6 to 9 per cent on an intraday basis. To add to the woes, the rupee dropped past 49 against the dollar to its weakest in nearly 25 months following a global sell-off in shares and as the US dollar extended gains against major currencies.

While the latest inflation readings have shown some respite, with food inflation easing to 8.84 per cent for the week ended September 10 against 9.47 per cent a week ago, the fuel price index climbed to 13.96 per cent as compared to 13.01 per cent. However, the chances of inflation correcting sharply are far lower, and the higher interest rates meant to tame inflation have started to impact growth. The decline in markets is broad-based, as the sectoral indices on the Bombay Stock Exchange showed a 2 to 5 per cent decline.

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Through the maturity extension programme, commonly referred as 'operation twist', the Federal Reserve intends to sell $400 billion of shorter-term Treasury securities by the end of June 2012 and use the proceeds to buy longer-term Treasury securities.

The economic situation, though gloomy at the moment, did not call for a third quantitative easing programme, given that Ben Bernanke has previously committed to keeping the federal funds (interest) rate at exceptionally low levels through mid-2013. Operation twist will extend the average maturity of the securities in the Federal Reserve's portfolio.

"By reducing the supply of longer-term Treasury securities in the market, this action should put downward pressure on longer-term interest rates, including rates on financial assets that investors consider to be close substitutes for longer-term Treasury securities. The reduction in longer-term interest rates, in turn, will contribute to a broad easing in financial market conditions that will provide additional stimulus to support the economic recovery," the US Federal Reserve said in a separate statement.

So what is wrong out there? Analysts believe that most of the Fed's lending rates are already near zero per cent, blunting the possible benefits of the measure. Also, according to IMF's Blanchard, what has happened is that markets have become more sceptical about the ability of policy makers and their governments to stabilise public debt.

"Worries have spread from countries at the periphery of Europe, to countries in the core of Europe, and then to others. Japan, even the United States," says Blanchard.

Worries about sovereigns have translated into worries about the banks holding these sovereign bonds, mainly in Europe, and these worries have led to a partial freeze of financial relations with banks keeping high levels of liquidity and tightening lending. "Fear of the unknown is very high."

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