Bullish Bank Nifty to set trend over next few sessions

In the past two years, the Bank Nifty and Nifty have moved in the same direction in 81% of sessions, and moved in divergent directions only 19% of the time

Will the Reserve Bank of India (RBI) actually cut rates next Tuesday? My answer can be no better informed than the answers of anybody else outside the tight inner circle of RBI committee members. As of now, there seems to be consensus that RBI will cut rates.

Should RBI cut rates? You will get many answers ranging from "Yes", to "No:" via "Maybe" and "Perhaps not". Most of those answers are driven by some agenda or another. In the long-term the answer to the second question is clearly "Yes".

RBI will cut rates, sooner or later. It cannot ignore the fact that inflation has dropped through the floor for almost every product and commodity with global linkages. The Wholesale Price Index has now been in negative territory for three quarters. Given 3.66 per cent change year-on-year, the Consumer Price Index is below the lower boundary of RBI's target-band of four-six per cent for January 2016.

As of now, if we look at commercial interest rates and fixed deposits, banks are paying a premium of three-four per cent over consumer inflation on their fixed deposits. Banks are charging an additional three-four per cent on loans. Those are wide spreads. Money is expensive, both for banks, and for borrowers. Interestingly, the difference between WPI and CPI is about eight per cent, implying manufacturing companies have enough pricing power to generate profits. But, corporate earnings have been flat for the last three quarters.

All that does not mean that RBI will cut rates on September 29. It might wait for more data to flow through. It may decide to see how hard the food basket is hit by the ongoing monsoon failure. It might look for turmoil in China (which affects India in multiple ways) to settle down.

However, given that a large number of traders do believe that RBI will cut rates, we have a slightly unusual situation. The Bank Nifty and the Nifty saw divergent moves on Monday when the Bank Nifty went up, while the Nifty lost ground.

Banks are the single largest industry segment in the Nifty, holding over 25 per cent of weight. When HDFC is clubbed together with banks, the financial segment represents 31 per cent of the Nifty's total weight. In addition, these are sensitive, high-beta stocks. The influence of the financial segment on the Nifty is strong and the correlation is high.

Rate cuts would be beneficial to the overall market, not just financial stocks. In fact, lower rates tend to push up broad stock market valuations. But the non-financial segments of the Indian market are seeing some selling pressure at the moment due to the overhang from the US Fed's gloomy statement and trouble in China.

In the past two years, the Bank Nifty and Nifty have moved in the same direction in 81 per cent of sessions, and moved in divergent directions only 19 per cent of the time. Assuming nothing major happens between now and the RBI's policy review, the Bank Nifty is likely to remain somewhat bullish. This could set up a situation where the Nifty is dragged in the same direction - that is, up.

If RBI does cut rates, the Bank Nifty could jump, at least temporarily. A five per cent move in two or three sessions is quite possible if a cut is announced. If RBI does not cut, there will be a drop but it might be more gradual. Either way, financial sector scrips will set the trend.

The author is a technical and equity analyst