Action in Bank Nifty

RBI could hold rates or go for a small cut. In either case, the market will be mildly disappointed

The credit policy will be among the key factors determining trends this week. There hasn't been a major build-up of speculative long positions in the past week, so the market is not over-bought. Let's run through some scenarios. If the Reserve Bank of India (RBI) raises the repurchase rate or the cash reserve ratio (CRR), the market will fall a lot. If it's status quo, the sell-off won't be severe.

If RBI cuts the repo rate by a minimal 25 basis points (bps), stock prices will stay stable. If RBI cuts the rate by more than 25 bps, the market will rise. If RBI cuts 25 bps and also eases CRR, there will be some gains.

Given the dollar-rupee trend, the central bank is in fire-fighting mode. Currency stabilisation is the priority item, while controlling inflation and enabling growth are secondary. Domestic macro-economic data suggests another cut could be on the cards.

The index of industrial production (IIP) data suggest that, at best, the economy is bottoming out. Cutting rates might help a little, if banks pass any cuts on. Consumer inflation is still above nine per cent but is dropping from double-digit levels. Wholesale price inflation has fallen below five per cent. One could argue that rate cuts amounting to about 125 basis points through the past 12 months had some effect and it would not be dangerous to cut some more.

The key elements in inflation are food and energy. Neither is dependent on or highly-correlated to rupee interest rates. Food prices are partly monsoon-driven and partly by government policy. Global energy prices will go wherever they may. The best the central bank can do to control energy-related inflation is to ensure that the rupee price of imported fuels doesn't shoot up by keeping exchange rates stable.

This brings us back to forex rates. The short-term effect of rupee depreciation is negative. A cheaper rupee makes exports more competitive, with a lag. But it will lead to a bigger trade gap, and a bigger current account deficit this financial year.

The fiscal deficit would also rise as crude oil, coal and gas imports prices will balloon in rupee terms. Hence, the fuel subsidy and fertiliser subsidy would increase, as would under-recoveries for energy PSUs. Of course, this would also push inflation up. There are also large overseas repayments due in 2013-14 and the entities with those exposures will be under pressure.

The RBI's actions, therefore, will be dictated by what it thinks is the acceptable currency band and the best way to target that band. This doesn't tell us, however, which direction it may choose in terms of interest rate signals.

RBI must judge the likely effects of rate hikes versus rate cuts. It will try to attract forex inflows. It cannot afford alternatives such as committing dollar sales to shore up the rupee. A rate rise may tempt foreign institutional investors (FIIs), which hold Indian debt to increase rupee exposures. A rate cut could, however, tempt FIIs to take larger equity exposures.

FII holdings in equity exceed those in debt. So, the central bank might be inclined to cut, and also, to talk the government into faster clearances and more liberal policy for sectors, which could attract FDI. It will not be inclined to hike rates at this juncture if it can help it.

Balancing the pros and cons, my best guess is the RBI will hold rates with a CRR cut. Or, it will make a small cut. In either case, the market will respond with mild disappointment. However, the market has just recovered from a bearish fortnight and it could easily go back into another bearish phase.

The Bank Nifty will be at the centre of attention. It could see a lot of volatility through the first three sessions of the week. As a trader I'd be prepared for daily swings of two-three per cent, which translates into 300-odd points in terms of high-low ranges. If a trend is established, the financial index could easily swing 1,000-points either way within this settlement.