Signals from credit squeeze & the Fed

Together with the elections these factors add up to a bearish outlook - and a great opportunity for long-term investors

One of the basic tenets of sampling theory is that distinct elements of the population must be adequately represented for accurate samples. The "early bird" quarterly results meet this criterion. The bigger companies in every sector report early (with the exception of public sector undertakings) and sectors tend to be adequately represented.

The results suggest growth across the economy remains weak. Apart from dollar-earners in information technology and pharma, there are no positive surprises. Among the big guns, Larsen & Toubro reported disappointing profitability, Unilevers reported disappointing growth in revenue and profits, Reliance made its numbers only through other income, Hero Motors lost market share, Asian Paints disappointed. Every metals major is bound to report lower numbers, given global commodity rates. Auto sales and realty offtake are both also in slowdown.

Financial players in Q1 benefited from lower interest rates. While bank credit volume did not grow much, net interest margins expanded because they refused to pass on the Reserve Bank of India (RBI) rate cuts. Those halcyon days are over. The RBI's credit squeeze of the past fortnight has reversed the easy money regime of the past year. (TIGHT MONEY IMPACT)

The latest Treasury Bill auction yields bear testimony to the panic this has caused in the rupee debt market. The benchmark 10-year government of India (GoI) bond is now at 8.5 per cent - up 95 basis points in the last fortnight. On July 24, the RBI reluctantly sold Rs 7,000 crore of Treasury paper at much higher yields than it had hoped for. The 91-Day T-bill hit 11-plus per cent, the 364-day hit 10.47 per cent. Cut-off for the July 10 auction prior to the squeeze had been in the range of 7.5 per cent.

Effectively, GoI yields have risen by about 3-3.5 per cent. That translates to higher than the hike at the marginal standing facility, where the RBI has reset rates to 10.25 per cent, up from 8.25 per cent. Apart from the spike, yield inversions at the short end suggest that the bond market is braced for another round of rate hikes. Banks have also started raising deposit rates, which is another signal in this direction.

The RBI will release its next monetary policy on Wednesday, just after the US Federal Open Markets Committee (FOMC) issues its next policy guidance on Tuesday (Wednesday morning in India). There could be some clarity on tapering time frames from the FOMC and that would undoubtedly influence RBI policy.

The RBI may do three things that the market would see as positive, regardless of macro-economic consequences. One, it could roll back the "temporary" squeeze it has instituted. Two, it could cut cash reserve ratio (CRR). Three, it could cut the repurchase rate or repo.

Consensus expectations are that the Indian central bank will stand pat, without roll backs, or touching the repo or cash reserve ratio. The RBI may just hike repo or hike CRR, if the FOMC decides to go ahead with tapering in September.

The credit starvation has pulled the rupee back up considerably, to below 59 a dollar. Volumes in both bond market and stock market have been very low in the past two weeks. This is partly due to the lack of rupee liquidity. It is also because foreign institutional investors (FIIs) are fence-sitting. They will take their next call based on tapering indications from the Fed.

For what it's worth, if the tapering does start by September-October, my guess is that the FIIs will sell more rupee assets. They have already cut rupee debt holdings to under Rs 15,000 crore, with sales of over Rs 42,000 crore in the past two months. The FIIs have also sold over Rs 16,000 crore of equity in the same period and they could sell plenty more.

Given a lack of domestic liquidity, we may not find counter-parties easily if FII selling happens. Mutual funds sold over Rs 10,000 crore of equity in July, due to redemptions. Domestic institutions have also been net sellers of about Rs 900 crore. If retail has to absorb concerted selling from domestic institutional investors, mutual funds and FIIs, the mind boggles at the thought of price levels where the market would clear.

I am unabashedly bearish at this instant and that too, bearish with a time frame stretching till the next general elections. If the RBI doesn't ease off, the lack of domestic liquidity will push prices down anyway. If the RBI does actually cut repo and roll back, etc, it may suffice to stabilise domestic liquidity but tapering would still drive equity prices down as FII sold. Note that US tapering will coincide with the build up of general election fever for at least several months. Election uncertainty can usually be guaranteed to knock prices down at least for a while.

Under the circumstances, the market has an excellent chance of falling by a big distance. The upside looks limited. Equities don't rise in the absence of liquidity, in the face of rising interest rates and in the presence of poor earnings and revenue growth.

The long-term investor could see this as a great opportunity. But it would be necessary to use gamblers' systems such as a systematic Scaled Martingale to average down efficiently into a long-term bear market. The investor would need to, say, increase investment commitment by 10 per cent every time the market falls 10 per cent.

Technically, the short-term trend reversed from 6,100 Nifty levels, as the RBI imposed the credit squeeze. The Bank Nifty, which is hyper sensitive to rates, has fallen by over 10 per cent. The Bank Nifty would remain the prime candidate for short-sellers and put-buyers if the RBI does what is expected. But anything outside the ambit of dollar-earners may be fair game for short-selling. Let me end with a reiterated recommendation for deep Nifty puts.