The Reserve Bank of India (RBI) has taken unusual measures in the past week. The central bank has been pushed into reversing its easy monetary stance due to the rupee's slide. Rather than defending the currency by selling dollars and reducing forex holdings, it has shored up the rupee by cutting liquidity. By making the rupee scarce, it is hoping to protect it.
There are interesting implications. RBI has already raised inter-bank rates in effect. This makes it unlikely that it will cut the repurchase rate (repo) or the cash reserve ratio (CRR) when it reviews policy on July 31. In fact, it increases the chances of a rise in repo or CRR if the rupee doesn't stabilise by then. The government treasury yields have jumped and the attempt to sterilise further by selling more bonds has only been partially successful, due to devolution.
Due to liquidity being at a premium, normal banking operations are stretched. Hence, there is little chance that commercial banks will cut lending rates. Foreign institutional investors (FIIs) have sold Rs 10,000 crore of debt in July, along with Rs 31,000 crore of debt sales in June. If FIIs continue to sell rupee debt in these quantities, there could be a problem finding counter-parties. Domestic institutions and banks might not have the cash in this tight liquidity situation and so, yields could rise further. The impact on already weak growth could be severe. It's likely that GDP growth in Q2 will be negatively impacted.
The effect on the Bank Nifty has been severe. It has fallen nine per cent since RBI cut liquidity. The chances of a further downturn are high if the tight money situation continues. In technical terms, the financial index has looked bearish since late June when it slipped below its own 200-Day Moving Average.
The recent behaviour contrasts with that of the broader Nifty. In the last month, the Nifty has gained about four per cent, while the Bank Nifty has fallen eight per cent. In the past week, the Nifty has gained marginally (less than 0.5 per cent), while the Bank Nifty has fallen nine per cent.
There has never been a sustained period when the broad market indices and the financial index have moved in different directions. Banks and other financials, which have also lost ground, have a high weight in the Nifty. Banking is the single largest sector by weight. The Nifty's upside has been sustained by bullish momentum in infotech, pharma and fast-moving consumer goods (FMCG). IT and pharma are debt-free dollar-earning industries, while top-level FMCGs like ITC and HUL are low-debt.
This situation cannot last too long. Either the Nifty corrects downwards or the Bank Nifty bounces. The Bank Nifty can only move up if certain things happen. First, RBI reverses the tight money stance. Second, banks deliver good Q1 results overall. Third, the monetary policy on July 31 is not as severe as the market fears it will be.
RBI has not set a timeline for easing supposedly temporary measures. Nor does it have a dollar-rupee target rate. It might decide to reverse next week before the policy review. Or it could carry on "temporising" with a tight liquidity stance. If it decides to carry on with the tight money policy, the financial index is bound to fall further and this time, might take the broader market with it. On the other hand, if the central bank does deliver positive surprises, the index could bounce back, maybe all the way till the 12,000 level.
Though this is results season and normally, the Q1 results of specific banks would have a larger impact, the liquidity position will probably override those. An option trader could, for example, play the short side with July puts at the 10,500 level. He could also buy out of money calls, even at 11,700c, or higher, at 12,000c, in the hope that RBI will change its liquidity stance. But it seems odds-on that the financial sector will be beaten down.