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| Bullish on currency |
| Devangshu Datta / New Delhi Mar 29, 2009, 00:55 IST |
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Going long on the dollar via the NSE's currency futures contract seems to be more attractive than buying it in the current market.
Experienced traders know Bond Street leads Dalal Street and Dalal Street leads Main Street. This relay effect is because liquidity instantaneously impacts bond yields and interest rates. Interest rates in turn, influence stock prices quickly while having a lagged effect on the real economy.
Developments in the past few months have been fascinating. In August 2008, the WPI (Wholesale Price Index) peaked at 12.9 per cent, year-on-year and started declining. By March 2009, it had plummeted to 0.27 per cent. The Consumer Price Index, was at 10.45 per cent in January 2009 when the WPI was 3.92 per cent.
During this period, the RBI cut policy rates by 500 basis points and reduced CRR requirements as well. The one-year Government T-Bill yield dropped from 9.5 per cent in August to 4.5 per cent by end-January. T-Bill yields stabilised at 4.5 per cent in January and have stayed there, despite subsequent policy rate cuts.
Banks have been unenthusiastic in toeing the central bank's easy policy line partly because they feared rising defaults in a slowdown. In August, bank PLRs (prime lending rates) were 14 per cent or more and home loans were around 12 per cent.
Banks have since started cutting. But there is a huge spread between current T-Bill yields (below 5 per cent) and commercial PLRs (12 per cent) and home loans (9.5 per cent). The implications are scary.
The government is paying real interest at about 4.5 per cent. With a consolidated fiscal deficit of 12-13 per cent of GDP, the GoI's borrowings are crowding out commercial lending. The commercial rates are exorbitant - far too high to induce retail spending or corporate investment.
Look at the monetary position in 2003-04 when the last recession ended. Inflation was then at around 5 per cent, with T-Bill yields at 7 per cent and home loans at around 9 percent. PLR was at around 10 per cent. In real terms, the GoI was paying 2-3 per cent while commercial and retail borrowers were paying between 4-6 per cent.
The rate-spreads of 2003-04 were substantial but not exorbitant. Spreads dropped through 2004-2005 and by the time rates hardened again, the economy had momentum. By analogy, banks must now cut PLRs and mortgage rates by at least 400 basis points to replicate the easy liquidity that helped end the last recession. It's true that every cycle is different but this seems a reasonable ballpark estimate.
How long will it take before rates hit acceptable levels? It depends on the banking industry and its willingness to cut. Until such time as that happens, a genuine bull market cannot develop. Nor will fundamentals improve much until rates are eased. Valuations may seem quite acceptable at the moment but there is simply not enough liquidity to spark a sustainable bull run.
Given the spread-mismatches in the money market, the current rally appears to be a flash in the pan. It is more likely one of those temporary pullbacks that commonly occur in oversold markets. Rather than seeing it as a buying opportunity, it would be sensible to sell into this rally.
Elections are around the corner. During those four weeks and until the next government is formed, political uncertainty will override all other considerations. The fear of instability should cause a termination of the rally and if prices drop considerably during the elections, valuations would become more compelling. A reprise of May 2004 is quite possible.
If you're seeking alternative investments or hedges, going long in the dollar via the NSE's currency futures contract seems more attractive than buying into the current market. The rupee has already hit record lows and it will continue to be under pressure during elections. If the Third Front does become a significant player, the chances are, there will be a mass exodus of FII investors. If that occurs, betting against the rupee could yield a big payoff.
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