Surfing The 2012 Financial Wave!

My friend was in Goa last weekend and was narrating his incidences when we recently met. Apparently, he had an amazing time there. Goa undoubtedly is at its best around this time. We had a good laugh at his experiences but being a Boring Finance Guy, as they say, I couldn’t help drawing analogies. One particular incidence that caught my attention was of my friend trying his hand at Surfing. A very inquisitive guy himself, my friend seemed to have borrowed a Surfing board from a Russian Couple and gave Surfing a shot. Listening to his experiences I realized that I, though not Surfing, was actually going through the very same apprehensiveness that my friend went through while doing it. Here’s how:

While surfing one never knows how big or small the next wave will be, there is a blend of expectation, experience and farsightedness which gives the surfer a judgment of the wave, a striking similarity are Financial Markets and its Players.

My idea here is to get a view of the financial wave that 2012 has in store for us; it won’t be possible to cover all the four asset classes as my knowledge is minuscule, so it will be more on the bond market and less on forex, equities and commodities.

Bond/G.Sec. Markets

All the developed nations have a pretty active and liquid bond market, whereas Indian bond market is not the same. In the last quarter though the Indian bond market has been volatile and has had good volumes too. 

RBI increased policy rates throughout FY 11-12 to tame a pretty stubborn inflation, which was largely because of high crude prices and food-articles. It’s only in December when food inflation has fallen and gone into negative territory, but one can not overlook the fuel price index which climbed an annual 14.45%. Going ahead, in 2012 food inflation is expected to remain under check largely because of the decent crop India has recorded which will help make up for the fuel inflation which is not expected to come down soon as Crude still looks to be in a bull market with limited downside. Crude is a factor which will prevent RBI from going on a rate cut spree, as crude has not fallen as much as other commodities and asset classes.                                    

RBI Policy Rate

 

The way forward for the Indian bond market mostly depends on the government’s budget and RBI’s monetary policy stance. The market has already factored a high borrowing (more than 5 lac Crores expected) for FY 12-13 but is looking forward to rate cuts in the face of dwindling growth and cooling inflation. The 10 year G.Sec will most likely trade in the range of 7.50% to 8.00% in FY 12-13, as possible rate cuts can push the yields down but the worsening fiscal situation will keep the yields under pressure.

The first half of the year can be positive for bonds as globally central banks are cutting policy rates and those who are not are keeping them on hold. Bank of England is expected to cut rates, whereas ECB has held them as it is. In Asia, Brazil has cut rates whereas cooling Chinese inflation and slowing growth has built rate cut expectations from the Republic Bank of China too. As there have already been signs of green-shoots in some parts of the Global Economy like U.S, India etc. an expectation of growth picking up momentum on the back of moderating monetary policy is very much there. 

The second-half can be a bit tricky for the bond market as IF growth shows momentum and world economies start heating up then central banks might have to check their stance to contain inflation. The possibility of these remains grim as Europe is not out of the woods and does not look like it will be soon as a country’s fiscal mess can’t be sorted in a whiff, which being the case U.S can still struggle with its growth and India will suffer on capital inflows and partially on exports too (Partially because the strong $ will benefit exports). 

The chance of U.S growth dwindling is pretty much evident in the mind of market players and is reflected in the U.S treasuries yield curve. The following graph shows how the 10 year and 30 year U.S treasuries have moved off late. The 30y-10y spread has been narrowing and at times the 30 year yield has fallen more than the 10 year, indicating a market bracing up for pricing a recession. This is also due to traders going short the front of the curve and long the mid and long ends which can result in a selloff in the longer end once risky assets are cheap. So net-net we can say that the whole year can be good for bonds and dicey for world economy.

 

The 30y-10y spread low was 0.19 in 2008 and the average was 0.66 whereas in 2011 the average has been 1.12 and the lowest being 0.92. The interesting part being that the last quarter of 2011 had an average spread of 0.99 and the low of 0.92 was then only.

Forex & Commodities

It will be the year of U.S dollar and I guess many will agree here, Reason? Well there are many, one as we all know Europe is in trouble and European banks are already in the line of fire. Dollar funding for major European Banks is pretty tight and whenever any rating agency gives downgrades to some the funding in the money markets ceases. As no one knows how much exposure a particular European bank has to Greek, Spanish or Italian debt which results in a high cost of dollar funding for all, that is the reason why off late European Banks have sold some of their foreign loans to realize dollars. The Euro has always been the currency where money flowed when investors has been vary of U.S, but the state of Europe has left people with no other choice than being in U.S dollar which is reflected in the strength the dollar index has shown in 2011.

Dollar Index in 2011

The Indian rupee has also suffered as the dollar strengthened, as stated previously people want to sit on cash ($) than any other thing at the moment, huge index ETF’s redemptions by some European Hedge funds not only left the Indian stock markets high and dry but battered the rupee too. The RBI has intervened in the Forex market but not much, instead it has tried to bring down speculative trading and arbitrage happening via offshore markets (NDF), which has helped the rupee slightly. The rupee won’t be seeing the highs of 2007-08 anytime soon as capital inflows won’t be strong on back of a poor global economic scenario and uncertainty about good corporate earnings in India. The rupee should probably trade in the range of 48-53 to a dollar for the year.

USD/INR Movement in 2011

Commodities: 

Gold has rallied a lot and is due for some correction, the main reason being institutions preferring to hold dollar/treasuries. The strength dollar index has shown is negative for commodities and going forward I expect the dollar index to remain strong and net-net a negative for commodities. Despite of this precious metal might still be able to perform better than others as risk aversion will result in money flowing into them and also the fact that people are comfortable holding silver and gold than other volatile commodities. Metals future depends on China more than any other factor; the slowing growth of China gives out a negative sentiment for metals. Agri-commodities also will have a bad year as a resilient global output and lower demand should keep the prices under check. The only commodity which won’t see a bad year as such will be oil, it has been the only commodity which has held its own and would continue to do so on the back of geopolitical tensions and a decent demand even in tough times. All in all one can say that we will see lower commodities prices in 2012 on the back of slowing growth and lower demand.

Many would still feel that 2012 won’t be that bad and I seriously hope so, it’s pretty clear that it won’t be a great year and we will see a fall in global economic growth, but may be an accommodating monetary policy and falling inflation will help the global economy consolidate and perform well after that.

Special thanks to Mr. Aradhya Dwivedi of FIMMDA for providing all the data/charts and for suggesting the title as well as the idea of writing something like this (So remember if you don’t like it- “it was Aradhya’s idea” and if you like it –remember I wrote it ;). Thanks buddy!

I request everyone who comes across this blog to kindly share their opinion as I am sure I might have missed out on something’s or could be wrong about things. The main reason of starting this blog was to share my views and get a feedback/opinion/knowledge from others as I don’t know everything but want to; the motive still remains the same. Cheers!

RBI’s Intervention in the Government Securities Market

RBI’s intervention in the foreign exchange market is pretty well known but is quite elusive in the government securities market. A recent data from RBI showed that they bought around 1100 Crores of G.Sec by intervening in the secondary market. An intervention in the foreign exchange market is usually to limit the strengthening rupee so that it does not pinch the exporters; the other is of supporting a depreciating rupee which is not done as often as the former is. In case of government securities the intervention is to stabilize shooting yields, as the cost of borrowing is a significant part while deciding the amount the government will borrow in a fiscal year. There are levels beyond which the government won’t be comfortable borrowing, these levels might be known to RBI or made known to them time to time and it is then the dealing room of the Financial Markets Department of RBI comes into action.

Some 7 to 9 months back (not sure about the exact time) there was a time when the 10 year G.Sec yield used to go beyond 8.00 % levels and then come down. The newspapers use to say that the high yields attracted investors, which you can trust once but not every now and then. It was then I was told by a senior veteran of the markets that it’s RBI intervening and not letting the yields go significantly above the 8.00 % levels.

The Indian G.Sec market is a highly news & comments driven market rather fundamentally driven will be a more apt description. Whereas, in our equity markets if one hedge fund decides to buy or sell due to excess or shortage of funds the result is something which defies all news flow or fundamentals on a given day. A recent comment by a MoF official that yields above 8.25% on the 10 year are not justified, was a signal of the levels above which the government won’t be comfortable borrowing. The RBI data showing GOI bonds being bought by RBI points out to the importance of such statements and are helpful for future course of actions as well. The frequent auctions of cash management bills reflect that the government is over-drawing from their WMA from RBI. On top of that the government is borrowing 2.5 lakh crores in the April to September period out of a total borrowing of around 4.17 lakh crore, if this slightly front loaded borrowing is done at high yields it will certainly hit the government badly a time when it’s trying not to borrow more than what they have said.

The market is expecting RBI to stop the rate hike cycle as the growth shows a slight slowdown but inflation has not peaked out completely, the RBI will be more concerned about inflation than growth. Even the government will wish to see the inflation come down as there will be elections soon in some major states where you can’t talk growth numbers as people will be concerned only about rising prices. There is a possibility that RBI might leave policy rates as it is this time and give a 25-50 bps hike if required in the next review according to the IIP and Inflation numbers in coming months. This rate hike pause can be due to the increasing pressure from banks, as the credit growth is sluggish (very less new disbursements) and the deposit growth being robust. This deposit-credit growth gap is a positive for government securities market but will affect banks margins.

The more prudent approach will be to continue with the rate hike as it’s more of demand side inflation now rather than the supply side and brush away the banking sectors concern of credit growth etc. It will be interesting to see what the RBI does as a rate hike and RBI’s stance (which has been hawkish so far) will certainly push the yields above the governments comfort level of 8.25%.

The Inverted Indian Yield Curves

The yield curves are one of the most interesting and sought after information/direction provider for dealers, analysts and economists in particular. Liquid yield curves of countries such as of the United States serves as a leading indicator of the state of the economy and is used for various analysis by economists.

The Indian yield curve is an illiquid curve, it is liquid only at some specific tenor points, like the G-Sec curve at present is liquid at tenor points 7, 10, 11 years and semi-liquid at 5, 16 and 30 year points. Among the Indian swap curves only the OIS curve is liquid and that too at only three tenor points, i.e. 1, 2 and 5 years.

For quite some time now the Indian G-sec curve has been inverted at 5y-10y (a spread of around 10 basis on an average), which reflects that the market is worried about inflation and liquidity in the shorter to medium term but does see inflation cooling with time and expects the growth also to slowdown, which was recently supported by the lower GDP growth numbers. From the current hawkish stance of the RBI it is pretty much clear that the central bank is ready to sacrifice growth in order to tame inflation. Inflation on the other hand is at elevated levels due to high oil and other commodity prices, which are bound to come down once the effect of QE3 subsides. A faltering U.S economy, an inflation struck Chinese economy and a debt ridden Europe signals towards cooling of commodity and oil prices. These signals can eventually lead to an overall slowdown in the global economy; it will again be a challenge for emerging economies to handle volatile capital inflows in such a scenario, given that the emerging economies are not battling with high inflation even then. There is also a possibility that there might be no volatile capital inflows in the emerging markets in case of a faltering U.S economy and Europe problems, as the last time QE3 was a major driver of the inflows coupled with low interest rates in the developed economies. It will be interesting to see how the future unfolds, will we have a QE4 from the Federal Reserve’s in case the U.S recovery falters further and where will the hot money flow, are questions best answered by economists I guess.

Coming back to yield curves the Indian OIS swap curve inverted recently, the 1y-5y swap rates have had a spread of around 5 basis. This was mainly because of an expectation of short term rates rising dramatically due to advance tax outflows, as daily liquidity is already in the negative 50-60K Crs according to the LAF window. Also, the 5 year OIS rate has dropped more than the bond yields have, which shows that there are people willing to receive a swap. When a person is willing to receive a swap in layman terms I infer that one sees interest rates coming down, which again supports the G-Sec yields as they reflect a lower inflation(lower crude prices), growth number and hence lower interest rates in future. Also the global picture of a slowdown justifies the flurry of people ready to receive an OIS swap in the long term and pay a swap in the short term.

Kindly do post your feedback as I have written some “financial gibberish” which needs to be refined.

The solution…………………………………..

To be honest even I don’t know what the solution to the problem I posted is.  As some people have said that I should only go on and give the solution. So here  I am doing some loud thinking which might result in something gibberish, but I dint name the blog Financial Gibberish for nothing (I have the liberty).

The first and the most obvious point is to build more reserve capacity which I guess has already started as the oil ministry has proposed to built a capacity of 1.33 million metric tons at Visakhapatnam on the east coast. The nation’s storage capacity will rise to 5 million tons when two more terminals are built at Mangalore on the west coast by 2012. That’s equal to two weeks of current imports. Still we require more such capacities to be built as a 60 days reserve will serve as a decent cushion considering India’s dependence on oil imports. I would also like to stress on the point that these reserves will help in times of such geopolitical issues where supply could be interrupted.

The other serious issue which needs to be addressed is the liquidity part. The oil imports suck out the liquidity in the Indian markets, as to buy oil the oil companies have to pay in dollars which they get in exchange of rupees. Consider the present situation of our banking system, we are somewhere in the negative Rs.80000 Cr to Rs.1 lakh crore when it comes to liquidity on a daily basis. Imagine what impact huge oil imports will have on this present state, the imports will not only be very expensive but the call rates, volumes in the LAF window and bond yields will jump significantly in order to fund the oil companies. The solution to this is open for discussions as I have no clue at the moment.

The only suggestion I have is that oil companies should not buy oil from the spot market so frequently and should book commodity futures/forwards in the international market (which they are allowed to book with a bank) and hedge the currency risk with a forward (again this is allowed to them with a bank). I have been told by many bankers that corporate usually don’t book oil forwards forget hedging the exchange risk by booking usd/inr forwards. The reason which they usually give is what if the crude prices fall in future and we would have locked in a higher rate.

One can just hope that someday sensibility will prevail.

Middle East - A complication for the existing structural issues of India

The trouble in the Middle East which has most of the OPEC countries in the belt is a potential threat to India, that too in a much more significant way than any of the developed or emerging economies. The international crude oil market has already factored in the distress in the Middle East countries.

The problem for India is not only that they are the 8^th largest net importers of oil (1,200,000 barrels per day), but 21^st when it comes to oil reserves. The steep rise in international crude oil prices not only means havoc for the Indian Oil Marketing companies but the countries fiscal health as well. Currently the OMC’s (Oil marketing companies) in India are losing 1 lakh crore by selling petroleum products at subsidized rates. The government has decontrolled petrol prices which already is fuelling inflation amid rising food inflation and a strong need is felt to decontrol diesel prices otherwise another subsidy burden awaits the government.

All said and done the problems in middle-east might ease out in sometime but it will be pretty optimistic to think so, in such events any country who has a reasonably good oil reserve will not face as many issues as a country like India which runs to the spot market every now and then to buy oil. The U.S has been able to increase its strategic crude oil reserves to a decent 60 days of storage where as India has been forced to buy spot at peak rates due to low strategic storage capacity of its refiners and stockist. Of late, India has started building a grossly inadequate strategic crude storage capacity of two weeks compared to the 60 day storage capacity of U.S and 90 day capacity of Germany and France. Even China which is at times inappropriately considered India’s peer has embarked on a project to store 90 days of oil by 2020 to meet its energy security.

The solution…………don’t we all know that.