RBI policy: Make or break for financials

Traders should be ready for a swing of 1,500-2,000 points in Bank Nifty

The Reserve Bank of India (RBI) policy review on Tuesday could be make or break for financials. The central bank has a very difficult call. Inflation is up, the rupee is down - that calls for tighter monetary policy. On the other hand, growth is down and that calls for an easier monetary policy. I have no idea what the "correct" decision is, in textbook terms. However, RBI has generally erred on the side of caution. It has already tightened inter-bank lending rates twice and put a ceiling on daily liquidity in the banking system. So, it is likely to either hold policy rates and cash reserve ratio unchanged or perhaps raise one of these. Or, if it thinks the situation is at crisis-point, to raise both interest rate and CRR.

I think the central banker's logic will run on the following lines. There isn't much RBI can do about growth recovery and cutting rates will not help. (RBI has cut the repurchase rate by 1.25 per cent since June 2012 without much growth stimulation.) However, a rate cut could trigger another run on the rupee if it triggers another bout of foreign institutional investor (FII) debt-selling.

More pressure on the rupee would not be healthy. If rates are held steady, and the rupee is stable, growth will eventually recover. If growth doesn't recover, the blame will be laid at the doors of politicians. In contrast, a currency crisis could lead to fingers being pointed at RBI.

Actually, FIIs don't have much rupee debt left to sell. They have already sold Rs 42,000 crore in the past two months. Their debt holdings now don't amount to more than Rs 15,000 crore. A rate cut, therefore, would not trigger much debt selling and might encourage equity buying. However, a rate hike or status quo could trigger equity selling and FIIs do have huge rupee equity holdings.

As a trader, how does this affect the perspective, especially on the Bank Nifty, highly sensitive to rate changes? The financial index is well below its own 200-Day Moving Average and has been lower than that benchmark for several weeks. This suggests the long-term trend is down. But the stock market has been extremely volatile and the 200-DMA signal has to be taken with a pinch of salt.

The most likely action if one goes by market consensus seems to be that RBI will leave rates unchanged. In that case, the index will fall. It has already tested support at 10,500. The 52-week low of 9,815 is 700-800 points below current levels.

A negative surprise such as a rate rise, or a CRR hike, should take the Bank Nifty down sharply. On average, the Bank Nifty swings around 200 points a day. It can move much more when there's a monetary review or currency fluctuations in the wind. Three big bearish sessions could take it down below 9,800.

It would take a positive surprise to move the financial index higher. RBI can deliver three possible positive surprises. One, it could remove the temporary caps it has placed on inter-bank liquidity and help reduce the Liquidity Adjustment Facility (LAF) rates back to 8.25 per cent. Two, it could cut CRR. Three, it could cut the repurchase rate by, at best, 25 basis points.

If it delivered all three positive surprises, the index might have enough momentum to cross heavy resistance at 11,000-11,100. A trader should, therefore, be prepared for a minimum move till 9,800 (down 800 points) or a move till 11,100 (up 500 points) in the context of the next five sessions. A maximum move might be till 9,500 or 11,500. This is a swing of roughly 1,500-2,000 points.

Under the circumstances, given reasonable option liquidity, the trader could consider taking a strangle of a long 10,000 put (premium of 180) and a long 11,000 call (181). If either level is struck or exceeded, the returns will be in the range of 30-50 per cent.