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!