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RBI will cut slowly

Domestic investors, who have been net-negative on equity for two years, will enter when the rate cycle turns

Devangshu Datta  |  New Delhi 

The easing in the is token. It will take effect with a lag. So, it doesn't make too much practical difference. The market isn't too excited. Most traders were hoping for more and even though the shot up to a new 52-week high, it was unsustainable.

However, this could signal a trend reversal in the interest rate cycle. may travel down through the next two years. The sentiment of domestic investors will get more positive if traders and investors become confident about a falling rate cycle.

The started raising the repurchase rate (repo) in early 2010, from around 4.5 -4.75 per cent levels. It was pushed to 8.5 per cent and stayed at those levels till early 2012. It came down slightly in mid-2012 and then stayed flat until Jan 2013. Apart from the repo, the has also cut Cash Reserve Ratio (CRR), which should create easier conditions. Note that in the previous full-cycle, repo peaked at above 9 per cent in 2008.

These numbers cannot be extrapolated exactly forward. But it would seem that the rate cycle can see a swing of 4 per cent or more in the repo rate, from trough to peak. Each phase of the cycle can last several years. There is always a lagged effect feeding into the real economy and that is also an important variable.

Falling rates make a big difference to market valuations. In theoretical terms, one compares the yield from a basket of to the earnings yield of stocks (the inverted PE ratio). Since the interest yield is less risky, the earnings yield should be at a premium to the interest yield. The higher the earnings yield, the lower the Hence, the sustainable PE for a stock or a market drops as the interest rate rises. Conversely the fair value rises when the interest rate drops.

In practice, other factors come into play. Investors bet on growth rates improving, debt-equity ratios improving, impact on forex rates, etc. It's more an art than a science guessing what the fair valuation of a given stock or a given stockmarket should be, given a basket of

But there is broad consensus about the direction. If rates fall, stock prices rise. Equity markets are famous for over-excited responses. In a panicky downtrend, stockprices will get driven far below fair valuation and vice-versa, they will be pushed well above fair valuation in an uptrend. As the market moves up, more traders start riding the bull. This pushes prices up further, enticing yet another round of players into the market. This phenomenon of trend feedback loops making a trend even stronger was called reflexivity, by Karl Popper.

Reflexivity is important. In its absence, any standard valuation model suggests India is over-valued. The has a valuation of PE 18-20. That equates to an earnings yield of about 5 per cent. It would be fair value versus an interest rate basket with a yield of say, 4.5-5 per cent. The 10-year government paper is trading at 7.9 per cent after the cut. Commercial lending rates and personal loan rates are way higher.

The rational argument in favour of investing in stocks would be that a) rates will get cheaper and b) earnings growth will improve as liquidity fuels demand. Both are true. But there would have to be a huge bounce in earnings growth to say, 20-25 per cent. The repo would also have to be cut by at least 150 basis points before the current valuations can be justified. That could take 6-8 credit policy reviews.

If reflexivity does come into play, the rate sensitive sectors will obviously benefit more. Banks and non-banking companies will cut deposit rates earlier and also by more, than they will cut lending rates. Debt mutual funds become attractive since their NAVs automatically adjust upwards.

As the cuts pass through into floating mortgage rates, it will make a difference to the housing market. By extension, it may cause a revival in construction, real estate, construction materials, etc. Other rate sensitives such as the auto- industry and other working capital intensive businesses will eventually benefit.

This scenario of a virtuous cycle depends on two main assumptions. One is that the will continue cutting. The second is that reflexivity will push the market up. I think the will be cautious. But it will cut every so often. Reflexivity is almost a given. Domestic institutional investors have been net-negative on equity for two years. They'll jump in as the rate cycle turns.