Park money in short-term funds, wait for cycle to turn

Interest rates have risen steadily with the RBI hiking policy rates multiple times in the recent past. The 364-Day T Bill (364 DTB) was auctioned at a yield of just under 7.5 per cent in January 2011. The last May auction saw it sold at 8.3 per cent. The 10-year G-Sec was sold at 8.33 per cent at the same time.

The difference between the risk-free 1-year yield and the risk-free 10-year yield rate is negligible. This is a distortion - normally, yields should rise with the tenure of the instrument when the credit ratings are the same. A flat yield curve is one step away from a yield curve inversion - a rarer situation when short-term yield exceeds long term yield.

The implications of a flat or inverted curve is bearish. From first principles, yields rise when prices fall. Price falls when demand is low. If demand for long-term debt exceeds demand for short-term debt, flat or inverted curves occur.

This suggests nervousness about short-term debt, usually due to expectations that short-term rates will rise further. An expectation of higher interest rates translates into risk-averse behaviour for businesses and individual consumers. Discretionary consumer spending and business expansions slow down. This expectation can be self fulfilling and cause lower growth or recession.

The classic interpretation fits the current picture. Other rates have risen across the board along with government securities and of course, everybody seems to think another rate hike is around the corner. Unfortunately India doesn't have a liquid well-populated secondary bond market. So, the yield signals are perhaps, less reliable than one would ideally like. Still, bond market action can be a leading indicator of stock market action and there is already a bear market in debt mutual funds, alongside the equity bear market. One of the best strategies in such phases of the business cycle is inaction - wait for the cycle to switch in your favour.

If you want to be aggressive, move from long term debt and perhaps, from equity, into short-term money market funds. These will lose the least value during a rising interest rate cycle. Then set what you consider a sequence of acceptable trigger signals and invest heavily when those are hit. For example, you may decide that the rate cycle is on the verge of switching if the yield between the 364-D TB and the 10 Gsec widens again, to say, 1 per cent. Or you may decide that you'll wait for the 364-D TB yield to slide back till the 7.5 per cent level. Or you may decide to wait for the Nifty to drop to 5,000 levels. Once your preferred set of buy signals is hit, move your cash back out of short-term debt and into equity and long-term debt funds again.

The author is a technical and equity analyst