The GO-od OLD days – gone?!

Gold may be all set to lose its glitter as the traditional safe haven asset. The chart depicted above traces the price of gold in the past 1000 days. Clearly there has occurred a reversal pattern with price action breaching and staying below trendline. So long as it remains below $850, gold could see pressure towards $600.

Falling gold could perhaps sound absurd in an environment of geo-political risk looming large and returns on virtually every other asset class proving negative. But that’s precisely what the charts are saying and it would be interesting to see in the next few months whether the forecasts as per charting analysis stand vindicated….

Possibly, given that a trend reversal is in place, it may mean that the spectrum of deflation may take centre stage, meaning depression in the United States and gold which is seen as a hedge against inflation will quite naturally have to lose its shine!

AN INGREDIENT FOR DISASTER

With hardly a glimmer of hope in sight, it seems that amidst all this aura of gloom and disappointment by many an economic entity, there is perhaps one individual who would be all smiles as the mayhem unfolded – none other than Mr. Bin Laden!!! For what he could not achieve through the 9/11 attacks, the US of A with its well-prided “cream of financial intellectuals” has most “successfully” executed the ECONOMY-SUICIDE Attack.

Well, to put things in perspective, WHO or What exactly murdered Wall Street and is now on a rampage across every other Street? The Answers may be endless, but all essentially boiling down to one aspect, which put across in refined parlance would mean Lack of Discipline or crudely put - Greed.

By whatever term you may call it, this emotion which is probably as old as the human race is at the very heart of the crises. And the irony is that while everybody knows it intuitively, nobody wishes to acknowledge it.

Way Back in 1995 when the hedge funds industry begun assuming tremendous footing in the financial world, leverage caught on as the fanciest means to make Big money quickly. All was well until Long Term Capital Management collapsed in 1998 – a Hedge Fund which at its peak commanded around $ 4bn in assets. And what aided this was the fact that the fund was able to take on infinite leverage or unlimited risk in practically every other asset class-commodities, stocks, currencies and bonds. What’s worse is that LTCM conducted and published much of the research, validating the risks of the trade for the rest of the industry. It was easy for LTCM to convince and impress investors for 2 reasons-one, it employed strategies so complex that no lay investor could probably trust his/her own head with and two, it had 2 Nobel laureates in its payrolls.

As huge bets paid off initially, no-one felt the need to question the source of the profits. It suited banks and other commercial lending institutions not to take the procedural due diligence too seriously. For ultimately the loans they lent yielded huge returns; End of day, targets were met which raked in huge bonuses.

Surprising isn’t it?? Exactly a decade later, the world find’s itself mired in a crisis that’s probably LTCM raised to the power of…. Anybody’s guess! From an endless pursuit of Return ON Capital, it’s now virtually a question of Return OF Capital that is seen driving sentiment across financial markets.

The crisis as we know it today all began sometime back through a seemingly innocuous financial innovation which was aimed at including millions of otherwise excluded families to fall under the “home-owners” category. Real competition was introduced in the mortgage lending business by allowing non-banks to offer mortgages. It didn’t stop there. Mortgages were allowed to be pooled together to be further used as collateral to issue securities. They were then sold to yield-hungry investors (and speculators!) alike and mortgage payments, consisting of interest and principal, were passed through the chain, from the mortgage servicer to the bondholder. The final icing on the cake was to call reputed rating agencies to certify that the “less risky” of these mortgage-backed securities were indeed “safe enough”. All this was not bad after-all or so it was believed to be…..as another mechanism to tackle defaults was created- the Credit Default Swaps market which later became an instrument of speculation instead of insurance.

It seemed like nothing short of a Dream product that America could showcase to the entire financial world. Sadly however, it stands today helplessly owning a crisis that would probably make the Asian financial crisis of 1998 or the dot com burst of 2000 seem like dwarfs.


Leverage yet again proved to be the culprit. Greed sent risk taking to dizzy heights, the effect of which is seen today as the cascading influence of panic and fear play out. Even as the wounds of such a meltdown remain raw, it pays to note that much of the risk taking, apart from being permitted was infact encouraged or better said-INCENTIVISED.

Closer home, the derivative debacle that occurred some months ago points to a fact that in essence, is no different - except of course for the magnitude of the problem. Here again, it originated with unrealistic targets set out by some of the managements of the banking sector to their treasury departments, which drove many a treasury official to aggressively market such products to corporates .Nothing really mattered to the treasury sales team – not even if it suited the risk profile and intrinsic business structure of the corporate. And quite a number of corporates fell for the bait of quick returns, as it came on the back of a sales gimmick – “x currency has never hit a particular level in the past 10 years and thus will not in the future”. Even though it sounds as baseless as saying, “I haven’t met with death in the past x years and therefore, I will not perish in the next y years”, the lure for overnight riches can send even the most “conservative” or rational/level headed firm or individual to assume risks beyond its capacity.

Risk per-se is nothing wrong for without it there is no business and most importantly no return. There is one common thread that runs across most cases, be it the large investment bank which went under the weight of its exposure to the mortgaged backed securities or the small scale retail investor in the equity markets – each of them were presented with a reasonable timeframe of positive payoffs. So Risk did payoff. It’s just that they didn’t choose to book their profits and exit their profitable positions.

The importance of managing risk can be summed up in the words of the great John Maynard Keynes who said, “Markets can remain irrational longer than you can remain solvent “. A thought worth its weight in gold!

AN AVALANCHE THAT WAS….

As the whole world suddenly awakens to the ruthless face of Free market economics and its nasty verdict, it is indeed ironic that the world’s largest proponent of laizze faire should have found itself falling prey to the “invisible hand” , better known as “efficient” market forces .

The historic Bear Stern’s takeover (bailout) by JP Morgan early this year virtually tricked many, if not all into believing that the worst of the crisis had come and gone, when in effect it only foreshadowed the fate of many that were to follow.

It was a week that underscored the alarming intensity of the credit crisis to an extent that it brought back haunting memories of the Great Depression to the world of Banking and Finance.

It appeared as though the whole financial cave-in was just waiting for the slightest trigger. And well, the honors were done by none other than the Fannie-Freddie combine, who effectively communicated a short but strict “THE GAME IS UP, Folks……..!! “ message to the over-glorified, over rated investment behemoths who ruled Wall Street for decades, packaging almost anything under the sun in the name of exotic “high-yield” products.

With Lehman filing in for chapter 11 bankruptcy and Merrill Lynch selling itself in less than 24 hours to Bank of America - fearing to face a similar ruling like Lehman if it had to face the markets on the first trading day of the week, the cascade had set in motion. An interesting point to note is that Lehman had survived two world wars, the Depression, a currency crisis and the Sept. 11, 2001 terrorist attacks that destroyed its former headquarters in New York. It was even acclaimed just a year ago, as being one of Wall Street's best-managed firms .

Even as the world watched, visibly stunned at the Fed/Treasury’s conscious decision to stay off and let the 158 year old company become history, America’s biggest insurer AIG sheepishly lined in next, seeking for a rescue.

Despite the dirty turn of events, the FOMC decided to keep its benchmark rate unchanged at its regular meeting slated that day, much against expectations. However, in the next couple of hours decided to do what no central bank had ever done before, namely insuring the Insurer by loaning out $85 billion to be repaid over the next 2 years.

As panic and fear spread across, the apparently safe money market funds came under strain, losing its foremost characteristic of being highly liquid. Reserve Management Corporation said that due to the Lehman bankruptcy, the value of its sponsored Money Market Fund shares had fallen below par, which in turn triggered redemptions, worsening the liquidity-starved interbank market.

As investors pulled out of money market funds, they quickly sought cover in the T-bill markets, which saw 3-month rates drop to a record low of 1 basis point. This prompted central Banks all over the world to inject dollar liquidity worth $180 billion into their systems in an attempt to kick start the critical working of the money markets. Apart from this, the Fed also came up with temporary guarantee program for US MM mutual funds, by which it insures for one year the holding of any public offered eligible money market mutual fund, retail and institutional.

The slew of measures didn’t quite restore the needed confidence as it only meant a stop-gap solution aimed at addressing the liquidity crunch in the system. The precedent set by the FED clearly saw the system crying for something more – of the kind which addresses the very root of the problem, namely the junk asset/mortgage backed securities (now, not even worth the paper on which it is written on!!! ), which is all over the balance sheets of Wall Street.

Even as the “ingenious” (?) $700 bn rescue plan hangs in balance; there is one very interesting and vital lesson to take home. That if the “invincible” Wall Street is today, more or less razed to the ground, then that is the power which the Market mechanism possesses-one that does not discriminate between how big or small you are. Doesn’t really care for how long you’ve been in existence. It can be the most rewarding force and yet be merciless, simply because it operates not with a heart but a mind, which understands only one language-the language of efficiency and discipline. And therefore, any excesses in the form of too much greed or over-leveraging or excessive-spending or for that matter absolutely anything beyond what is to be, the MARKET will most certainly bring back into equilibrium, even if it means much pain and elimination.

While pushing through a rescue to the tune of $700 bn may just about help ward off an immediate collapse of the system, the cost however would be manifold

- the Fed risks setting a precedent, which implicitly encourages sub-efficient processes/systems/products to continue unchecked.
- Reckless policies to continue without any accountability and lastly
- push the US economy into a predicament of even greater proportions as it would then need to attract an approx $30 bn per month (approx $ 10 bn pm on the Iraq war is spent) for the next 2 years to fund the same. This is wholly apart from existing deficit it runs on virtually all its accounts(fiscal, trade and current)


Mr. Paulson and Mr. Ben Bernanke would do well to consider the many implications and respect the House’s verdict on the rescue plan coz if the INVISIBLE HAND could whip Wall Street, then the so called Sovereign, Risk-free US Treasuries may not be far behind as it may become the most riskiest asset around eventually……


……………..Makes sense, coz logically who would come forward to bail out the Federal Reserve??!!

WHY THE FED SHOULD REMAIN ON HOLD

It’s been quite an innings in the currency markets now, with the tables finally turning in favour of the beleaguered dollar. While much of it surrounds the cliché “yield differential” argument, traders have virtually punished the euro and sterling for the same reasons they hammered the dollar not so long ago. Which again brings us to the question, should the FED succumb to the inflationary threat that sees its latest numbers hit a seventeen year high of 5.6% year over year?

To answer this, it would be worthwhile noting at the outset that it is still a lot premature to say that Uncle Sam is totally out of the woods, as the economy is yet to fully clean up the financial mess it has found itself in.

Sadly, much of the financial press tends to erroneously conclude that if the dollar is out of danger zone, so is the economy that it represents. However, any currency trader worth his salt would tell you, that currencies hardly reflect their intrinsic strength or weakness in the near term for the simple reason that the component of those invested in currencies pales in comparison to those speculating in them. For example, the astronomical rise in euro was not so much on account of any spectacular strength in the European region; rather it was driven up more as an anti dollar vehicle. If this is true, then we could even see a weird combination of rising dollar amidst a weak economy going forward. Here again not because of US economic strength but that weakness in the EU could get a lot more highlighted.

Much as was the whirlwinds that blew over the seemingly never sinkable US economy – the TITANIC of the economic landscape, the FED should by all means refrain from buckling to the pressure of hiking rates, particularly in an inflation-stained election year, even if it means sporting a negative real rate of return on its securities.

The continued monetary measures taken by the central bank since August 2007 in easing liquidity has helped soothe the financial strain at least to some extent. While a further round of easing may actually be needed, the central bank should at least keep rates on hold for some more time until the credit shocks stabilize and progress into a recovery that is both tangible and sure-footed. Any attempt at hiking rates immediately would be an impulsive response to inflation that would risk derailing any recovery either current or potential. With almost $3 trillion shaved off from American home values, it is hard to see how the US economy would be able to face a resumption of a restrictive policy.

It seems unlikely that Bernanke will undo what he has done this far in a manner that would render all his aggressive efforts futile. Any revisit in interest rates higher in the near term would bare open the risk of morphing the current bump with recession into a full blown depression for the US and the global economy following suit. Interest rates across the globe are likely to be headed south and the hunger for yield will continue to remain the unchallenged pursuit of every economic entity.

I end with the proverbial “If the US sneezes, the whole world catches a cold” to fall back on , and say that what the FED does in the next couple of months would either shape or mar the global economic framework for the next 5 years.

Impact of Monetary tightening

RBI today stuck to its tightening stance and hiked the Repo rate from 8.5% to 9%
It also tinkered with the CRR, hiking it by 25 bps from 8.75% to 9%.

Repo rate essentially forms the upper ceiling of the Liquidity adjustment Facility and constitutes the rate at which RBI would be willing to lend funds to banks .In short, it is the rate at which RBI injects liquidity into the system.

Given a background of tight liquidity as evidenced by virtually no bids on the Reverse Repo window, call rates close to 9% and inflation just a tad below 12%, this move of the central bank to further increase borrowing costs of banks can be seen as a measure to restrict the lending capacity of banks and thereby rein in credit off take.

CRR on the other hand measures the ratio of time and demand deposits that banks would compulsorily need to park with the Central bank. A hike in the Reserve requirements would affect the potential of the banking system to create transaction deposits thereby resulting in reduced money creation and, in turn, in reduced economic activity.

While seen as an effort to preempt any further build up of inflationary pressures, the above increases would have the effect of pressuring profit margins of banks and slowing growth in the forthcoming quarters.

Generally when the key monetary variables are raised, it has the effect of increasing forward premiums from the following standpoints:

- interest rate differential between US and India widens in favour of the latter and therefore the former nation’s (US) currency tends to gain in the forward market to eliminate any interest rate arbitrage today.
- Domestic bond yields rises which gets reflected in the forward premia.
- Banks in order to meet the increased margin requirements will need to attract more deposits - a proposition that is difficult in the very near term .Therefore banks tend to indulge in sell-buy swaps in the foreign exchange market wherein they sell dollars in the spot market and take an offsetting position by buying dollars in the forward market to get the requisite rupee funds. This has the effect of helping rupee appreciate in the spot while weakening it in the forward market

A liquidity crunch therefore, which continuous hikes in CRR inevitably help create, increases demand for rupee vis-à-vis the foreign currency, $. So generally the immediate effect of such a move would be to help rupee to appreciate in the spot market. The degree and extent of the rupee appreciation however ,would depend on the relative demand for $.In a scenario where FII’s are pulling out, naturally the rupee’ gains are checked by a simultaneous demand for dollar.

Macroeconomic impacts

A one off hike in the key variables is not likely to cause the below, but a steady course of hikes will mean a great deal of strain on the economy in the following ways:

Margins of corporate as a whole would come down sharply particularly highly leveraged companies. Unlike big corporates which can fall back in internal accruals and cash surpluses, small and medium scale industries which are wholly dependant on bank credit will be severely hit.

Capital expenditure projects and other expansion plans may get deferred, which could ultimately impact employment generation.

Consumption of manufacturing inputs and end use of life style products is likely to take hit.

Its impact on inflation is likely to be indirect , working its way through slower growth.

Much of the inflation experienced is either due to global pressures as in the case of oil or serious supply side constraints ( food articles). Increases in CRR and repo are unlikely to check this because the transmission mechanism works its way through the demand and not the supply side

Real estate prices could witness a correction as home loans get dearer and default rate increases.

As a final word the impact of these increases would help the rupee appreciate in the near term, especially if it is backed by crude sliding down. However, the long term impact would be to weaken the rupee as growth further moderates as the broader economy bears the brunt of steady hikes in borrowing costs. A case in point here is that the central bank is sadly targeting the WPI and not the more relevant Consumer Price Inflation, which continues to remain high and it would be interesting to see in the months ahead if monetary tightening manages to rein in the supply side phenomenon of inflation hitting the consumer.

OIL – Only In Longs??

With virtually every central banker and ruling political leader across the globe losing sleep over the vicious phenomenon of inflation and it’s seeming stubbornness never to subside, it seems – (or that’s what the charts say )…..that it just may be time to stop worrying about the biggest contributor of it, namely crude oil…..

So has OIL finally TOPPED??

Could seem like a million dollar question but recent price action gives us sufficient reason to believe that it has….at least for the time being.

As evidenced in the Chart above, there has been 2 consecutive trend line breaches coinciding with a reversal bar confirmation and a double top.

WE could in all probability witness a short covering rally in the next couple of days, that could potentially target anywhere between 132 to 135. There could be an extended spurt to 138 also. However if this recovery does not sustain above 138-140, the next leg of correction may be in the offing – a fall that could be targeting 105-110 levels.


Implications for our very own Indian Rupee…..

The rupee could retrace back to a 42.74 – 42.84 .If price action does not sustain above 42.85, the next round of correction could target anywhere between 41.25 and 41.50.

DEJA VU-2004

For those who’ve been around the currency markets for some time, the current dollar collapse may bear a striking resemblance to the reserve currency’s tumble seen not so long ago!

As the saying goes, History is a good teacher ‘coz unless you learn its lessons well when taught the first time …………it would repeat itself until you did!

Flash-Back to 2004……………...

The US was infact just coming out of a 1 year hiatus period after a series of rate cuts -courtesy The Fed, from 6.5% to 1% between 2000 and 2003.The theme, of course was quite different – it was the DOT Com bubble which popped numerically on March 10, 2000 when the NASDAQ Composite index peaked at 5,048.62 more than double its value just a year before.

June ‘04 witnessed a significant shift in monetary policy – a steady course of 25 bps hike to the benchmark rate that was to follow for the next 2 years.

And as the year progressed to encounter the verdict on the next Presidential vote, the dollar went on a tailspin, seemingly into a bottomless pit…… Almost every other news clip and financial journal had something to say on the dollar’s fate. Not to forget investors and financial experts across the globe railing and ranting over what seemed to be a possible “DEATH” for the dollar. Analysts and currency strategists were no exception, calling for a one-sided decline in the reserve currency right into the whole of 2005. Infact you would have risked being called a full-fledged fool if you’d even thought of being a dollar bull………

…………..and what was interesting in this entire episode was that the euro and sterling went galloping to new highs with each passing day, despite a slew of negative economic data being released from the respective regions.

And as everyone knows today, 2005 is recorded as a year which saw probably one of the best bull runs for the greenback.

So what lessons do we take home as we step back into the current reality of 2008………..A year that just witnessed a series of aggressive rate cuts by the Fed - the problem though was the housing bubble burst and the resultant Sub Prime crises. But then again, we have the 56th Presidential elections around the corner AND the dollar plunging to new lows, this time particularly against the commodity currencies apart from the euro. Take a closer look at the UK and Euro Zone data and you will find that there is virtually nothing to cheer about these economies from a growth perspective.

So if History has taught the right lessons we may have some very valuable pointers going forward. We could probably see the dollar being driven down further in the run up to the elections which would be the final leg of the fall, effectively paving the way for the next course of rally to maybe a 1.45 to a euro and 1.83 to a pound in 2009.Commodites is most likely to follow suit as a massive unwinding is likely to set in 2009 after an immediate final rally.

WELL Worth the Flashback…..huh?? .......Well,that’s again for time to tell!

A study of Rupee in relation to FII flows - 17th June 2008

Chart 1

Chart 1 captures the broad trend of institutional investment popularly termed as “hot money” and the domestic exchange rate a little over a 4 year period (Obtained by plotting the monthly average rupee rates vis-à-vis the corresponding Net FII flows in equity and debt.)

A closer look reveals an interesting relationship in that 67% of the times over the past 53 months, whenever FII net flows turned negative to the tune of Rs 3000 crs or more in a single month; it has had the effect of hitting sentiment for the domestic currency and has spurred a default dollar rally.

There seems to be a steady pattern even in this relationship:
- the first trigger is usually caused by FII outflows which takes the market by surprise and leads to heightened volatility leading to a sharp spurt in the dollar in a very short time span.
- This is followed by a continuation of the trend for a few months (anywhere between 3 and 6 months) wherein if FII flows stage a comeback to positive territory and remain positive for about 3-4 months in a stretch, then the dollar momentum wears out and gives way to rupee rise.

However in all of the above cases, the extent of rupee weakness in the face of FII outflows is governed by the principle trend of the overall price action. For instance, when price staged a break in the multi month uptrend of the $ in March 2007, an outflow of Rs 17000 crs in Jan 2008 coincided with the rupee hitting a high of 39.37(which is an exception to the above “normal” rupee response).

STATISTICAL (Regression) ANALYSIS - 4 instances of FII outflows and a resultant Weak Rupee

1) APRIL 2004 – AUGUST 2004

Chart 2

Zooming in on the first setback that the rupee faced in May 2004, chart 2 clearly shows, the inverse relationship (though to a lesser extent) between the independent variable (FII flows) and the dependant variable (rupee).

A mapping of per day’s FII flows and the corresponding rupee rate via Scatter plot in Chart 3 reinforces the underlying negative slope as obtained by the regression equation :

y = -0.0004x + 45.474

However the linear relationship is not very significant as the R square which spells the coefficient of determination is only .016. The R-Squared illustrates how well the Linear Regression Trend line approximates real data points.

Chart 3

An R-Squared of 1.0 indicates a perfect fit. Statistically the equation implicitly points to certain unexplained extraneous variable(s).This would typically relate to the jitters following the surprise outcome in the General Elections, trade deficit worries in the face of a dip in inflows and to a large extent sentiment, amongst others.

Chart 4 The final step in the above analysis was to plot varying values of the independent variable, namely FII flows and run a simulation based on the fitted regression equation and compare it against the actual rupee movement which was registered in the months, post August 2004.As can be seen in Chart 4, the variation has been quite substantial, as the fitted projection mostly overestimated the $

2) SEPTEMBER 2005 TO DECEMBER 2005

Chart 5

The next significant spell of rupee weakness is analyzed below using the same methodology employed earlier. The observations are as follows:

- The rupee witnessed a severe 6% round of weakness following multi month lack luster consolidation.

Chart 6

- Here, however the slope of the linear regression line turned mildly positive as seen in Chart 6.

-Though the initial trigger was provided by FIIs turning net sellers, it quickly reversed back into positive territory but rupee continued to remain weak
- Here again there is a huge unexplained component and surprisingly oil doesn’t feature in the list as it in fact declined 19% in the same period.

Chart 7

-This could be explained by the NDF related play which led to a trigger of a number of leverage structures and the sheer speed of rupee weakening sparked panic buying in dollars.
- However despite R square at .01, the actual rate that prevailed post December 2005 nearly coincided with the fitted projected curve after a lag of 3 months.

3)FEBRUARY 2006 to SEPTEMBER

Chart 8

Analyzing one of rupee longest streaks of weakness witnessed in 2006 validates yet again the impact that FII flows has had in moving the rupee into weaker territory.

Chart 9

Chart 10

One significant observation emerging from the regression analysis is that whenever the slope of the linear regression turns negative (as was the case even in April – August 2004); the simulated fitted trend line tends to consistently overestimate the dollar in the future for varying levels of FII flows.

4) APRIL 2008 till DATE

Chart 11

The new fiscal was greeted by the dollar virtually reversing all its previous year’s losses. Given the striking negative sloping linear trend between the explained and explanatory variable, it can be inferred from the above fitted regression equation that since the FII trend has not yet bounced into positive territory, chances are that a further slack in capital flows could prove positive for the dollar

Chart 12

Based on the above fitted curve, a projected scenario analysis at various possible levels of FII net flows would be as follows:

Chart 13
However since the negative slope has historically resulted in an overestimation of $ rates, there is every likelihood that the projected rates could possess an element of deviation. From the above projected, on the upside 43.71 would be a formidable barrier and likewise 40.68 on the downside in the event of rupee appreciation

A Study of the Rupee vis-à-vis the Black Gold -27th May 2008

Chart 1

The chart 1 indicates that the overall secular trend of oil has been to the upside. It has been a steady bull run that was interspersed by short periods of consolidation.

Medium term: Corrective dips would find key supports at 100-115.So long as price action is contained above the pink line, dips would provide bidding opportunities to take the rally forward.

Long term perspective: Real estate, equities and commodities were the three major asset classes that simultaneously witnessed swift appreciation on cheap money and easy liquidity (spurred by the Fed cutting rates to 1% that existed until June 2004).Of which housing and equities have taken a reasonably decent round of correction in recent times. Commodities is the only asset class which is yet to undergo a significant correction. This is expected to occur when the Fed stops its easing stance and switches to a tightening mode on account of inflationary pressures which will most certainly come to haunt the US economy possibly in 2009 (fallout of rates being aggressive cut together with commodity led inflation)

Thus in short, it is still too premature to call it a top for the Bull Run in oil. Having said that, a temporary top may be in place to set in motion a correction to the above mentioned support levels .However for a confirmed trend reversal, 85 would need to be breached convincingly.

Chart 2:

The rupee in contrast has witnessed a more convoluted price action which has been a combination of prolonged periods of consolidation and swift reversals .One noteworthy characteristic of the rupee’s movement is that volatility is greatest at turning points and diminishes as the trend becomes established.

Chart 2 reveals four significant depreciation spells that have occurred between 2004 and now.

Chart:3

April-August 2004 : The Rupee depreciated from 43.30 to 46.50, an approximate 7.4% fall during this phase, the main trigger being the surprise outcome of the Indian general assembly elections at a time when global risk aversion was also generally high. This had resulted in a major sell-off in Indian equity markets. Oil prices moved from $34 to $47.

September - Dec 2005: Despite a relatively stable global risk environment, the rupee spurted from 43.50 to 46.50 levels. There was no single reason but a host of factors namely, scant portfolio flows amidst current account deficit, opening NDF arbitrage, trigger of overly-leveraged structures. Interestingly, oil prices declined from $70 to around $57 during the same period.

February- September 2006: This period saw the onset of the commodity market boom, which fanned a huge spike in global risk aversion over fears of rising global inflation and impact on global growth which led to a huge sell-off in emerging market equities. The dollar notched up approximately 6.8% gains as it briefly kissed the 47 mark .Oil prices surged from $58 to about $ 77 in this period.

April 2008 to…………

The credit crisis and fears over a severe recession in the US economy had resulted in a major spike in global risk aversion at the start of the calendar year. 30% of the market capitalization was shaved off in equity markets in a span of days. Since then portfolio flows have failed to pick up even as signs of retreating global risk aversion has been noticed. There has also been a perceptible decline in announcements of fresh private equity deals. So, in a nutshell, the volume of cross-border capital flows has dwindled over the last few months. Unabated rise in global oil prices did trigger in panic buying of dollars. It is however interesting to note from the above chart that the rupee maintained its poise under 40 when oil prices initially climbed to 119.5. The rupee’s rapid fall was when oil climbed yet again past 119.5 levels.

Other observations:

Even when the rupee staged possibly its best ever rally from April 2007 until sometime back gaining a terrific 11% against the dollar, oil continued its steady upward march rising approximately 67% from $59 to $100, posting thereby a clear negative correlation. This period also witnessed a copious inflow into the capital markets, which to a large extent determined the rupee’s fortunes.

Conclusion
The rupee’s recent behavior can be seen as a lagged response to oil prices generally exhibiting an upward climb in the past several months, it can be seen that markets have responded differently to apparently the same variable.

During rupee appreciation phase, the same increase in oil was viewed as the reason to keep rupee appreciated to tone down the import bill and thereby the trade deficit. Markets now turn a blind eye to this reasoning as the economic impact of high oil on growth and the trade deficit argument take centre stage.

Going forward...

As noted earlier, oil could witness a correction towards 100-115 levels, which could be accompanied by the dollar slipping towards the 41.50/75 territory. Performance of the domestic bourses in relation to FII flows will also set the near term direction for the domestic currency.

Elections and Rupee

The period post the onslaught of economic reforms was plagued by a lot of political uncertainty and 1996-98 was particularly significant in this respect. It’s pretty evident from the Chart above that markets have always been averse to political uncertainty and the rupee by and large has weakened in the face of elections, political stalemates and surprise outcomes. Much of it is spurred by investors buying in the foreign reserve currency as a measure of safety till more clarity is seen in the domestic front. In fact the first time that the domestic currency breached past the psychological 40 level was during a challenging political environment.

The last year of the mlillenium proved to be equally volaile in that it was not only marred by political upheaval but hostilities with India's historic neighbour became more pronounced The 1999 Lok Sabha election is of historical importance as it was the first time a united front of parties managed to attain a majority and formed a government that lasted a full term of five years, thus ending a period of perceived political instability at the centre that was marked by three general elections held in as many years.

Most analysts believed the NDA would win the elections; this assessment was also supported by opinion polls. The party was supposed to have been riding on a wave of the so-called "feel good factor", typified by its promotional campaign "India Shining"

However the actual results proved the anti-incumbency factor at work. The stock markets (Bombay Stock Exchange) fell in the week prior to the announcement of the results due to fears of an unstable coalition. As soon as counting began, however, it became clear that the Congress coalition was headed for a sizeable lead over the NDA and the market surged, only to crash the following day when the left parties, whose support would be required for government formation, announced that it was their intention to do away with the disinvestment ministry.

Despite the prime architect of the economic liberalization of the early 1990s leading the coalition, the fear that reforms would take a back seat purely because of the Left-connection stood to haunt the markets and rupee remained weak close to 6 months before it recouped its losses on the back of FII’s evincing renewed interest in India’s fundamentals.


As a final word, history is testimony to the unanimous and consistent response of the Indian currency during the election/post-election periods. Odds are that the rupee could behave in a similar fashion and therefore we could expect heightened volatility in 2009 or earlier if political conditions warrant.

Sensex-Technical Analysis

The chart above indicates that Sensex has corrected very well, retracing exactly to test the 61.8% Fibo level from 8000 to 21000. 61.8% Fibo is an extremely critical retracement level, as most corrective waves of bull runs in financial markets form a bottom at this key scientific level. Having said that, if price remains under this 61.8% (in our case 12800) then the implication would be that price could retrace 100% - meaning if SENSEX remains under 12600-12800 then a fall to the start of the bull run namely 8000-8500 would seem increasingly probable. However immediately a good recovery may be underway towards the falling trend line resistance at 15000-15500 (see chart below).

For a clear confirmation that the corrective wave is done and over with and the SENSitive indEX is out of the woods, it would initially need to cross the 16350 hurdle followed by the 18000 mark to embark on its next bull run.

In the forthcoming days, it would be interesting to see if the recovery manages to break above the falling trend line, because failure to do so would spark the first signal that a deeper downside attack awaits the Sensex.