I made the case that Indian equities are now undervalued based on price to nominal GDP, but the market is still not trading at the extremes seen around 2002-end (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS)- those valuations imply a SENSEX level of about 7500. Where the final bottom lies will depend upon the evolution of global risk appetite based on the future course of economic and earnings data. Considerable uncertainty remains about whether policy stimulus will work given the continued problems in the banking sector. Absent any further shocks, I am leaning toward a scenario where the substantial fiscal response along with improvement in credit markets will lead to a feeble resurgence in late 2009 or early 2010. Markets will turn before that, but given the substantial uncertainty, I am looking for ways to avoid the downdraft should the recovery not materialize. To this end, I tested several technical rules that could help in playing this turning point profitably.
The results are preliminary, but based on monthly index data it does not seem that simple trend following strategies would be of great help. There is no statistical evidence of either momentum or reversal in monthly return data for the SENSEX and BSE-100. Market breadth – characterized by the advance/decline ratio - does not seem to have any predictive power either. The option market – call to put ratio - seems to have some contrarian relevance.
TREND IS YOUR FRIEND? NOT SURE
I tested for linear dependence in monthly returns for both the SENSEX and BSE-100 (April-2001 to March-2008). The results do not indicate any tendency for either momentum or reversal.
SENSEX
Return (t) = 1.9% + 0.06*Return (t-1)
BSE-100
Return (t) = 2% + 0.05*Return (t-1)
The regressions have low R^2 and the coefficients for lagged returns are not statistically significant. So a simple momentum strategy will not be of much help in our endeavor.
What about buying only when the monthly closing value exceeds the 12-month moving average? The results are no better than a buy and hold exercise.
12-month Moving-Average Strategy: Monthly Return Statistics
Mean: 2.5%
Standard Deviation: 7.0%
No. of Months: 61
Buy and Hold: Monthly Return Statistics
Mean: 2.6%
Standard Deviation: 6.8%
No. of Months: 71
Bottom-line, it does not seem that we can simply follow the market to prosperity.
WHAT DOES MARKET BREADTH TELL US? NOT MUCH
High breadth is a sign of a healthy market that is more likely to rise. To test this hypothesis, I regressed monthly returns with one month lagged advance to decline ratio (A/D) as the explanatory variable. The results are not encouraging.
Returns (t) = 2.6% - 0.002* A/D (t-1)
The regression explains about 9% of the variation in monthly returns and the coefficient of the A/D ratio is negative but lacks statistical significance. There does not seem to be any pattern in the residuals.
To take the analysis one step forward, I tested four trading schemes:
1.If the advance/decline ratio for the month is higher than that for the last month and current monthly returns are positive, go long the market, otherwise stay out.
Mean: 2.2%
Standard Deviation: 8.2%
No. of Months: 35
2.If the advance/decline ratio for the month is lower than that for the last month and current monthly returns are positive, go short the market, otherwise stay out.
Mean: -2.9%
Standard Deviation: 6.5%
No. of Months: 20
3.If the advance/decline ratio for the month is lower than that for the last month and current month returns are negative, go short the market, otherwise stay out.
Mean: -1.9%
Standard Deviation: 5.9%
No. of Months: 21
4. If the advance/decline ratio for the month is higher than that for the last month and current month returns are negative, go long the market, otherwise I stay out.
Mean: -0.15%
Standard Deviation: 9.1%
No. of Months: 6
Market breadth does not seem very helpful in improving investment performance.
OPTIONS MARKET A CONTRARIAN INDICATOR
If the call/put (measured by value) ratio trends higher, on average, traders expect the market to rise. I tested the predictability of this technical factor by regressing monthly returns of the BSE-100 on 1-month lagged call to put ratios on the NSE. I know that the exchanges are different, but cannot think of a reason why that should bias the results.
BSE-100 Returns (t) = 5.7% - 0.008 Call to Put Ratio NSE (t-1)
The R^2 is about 18%. The coefficient for 1-month lagged call to put ratio is negative and the p-value is 0.11. It seems that the options market gets it wrong on average and we can say this with about 90% confidence.
PRELIMINARY EVIDENCE NOT ENCOURAGING; FURTHER INQUIRY REQUIRED
There are obvious qualifiers to the above analysis: firstly, the data is not enough; secondly, I used only monthly data, it is possible that the indicators work for different periodicity; and finally, there might be non-linear dependence that our simple statistical techniques failed to decipher. The results are not conclusive, but do suggest that simple trend following strategies are not likely to help us negotiate the considerable uncertainty that clouds the investment landscape.
Source: HANDBOOK OF STATISTICS ON THE INDIAN SECURITIES MARKET 2008; SEBI
Monthly data from April 2001 to March 2008
Sunday, January 25, 2009
Monday, January 19, 2009
PERFORMANCE APPRAISAL
It is important to assess periodically what’s working and what’s not.
I will start with the trades with mixed results.
1. Long Indian bonds: I bought Indian bonds on December 14, 2008 (LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN). My prediction was that cash would outperform derivatives and within cash, I thought that a diversified basket of AAA corporate paper will swamp treasury returns. The market rallied. On December 28, 2008 (TACTICAL NOTES FOR EARLY 2009), I reiterated my buy call based on strong indications from authorities that rate cuts were imminent and that the likely easing was not priced in. The Reserve Bank cut the reverse repo rate by 100bp, but government securities sold off on fears of impending supply. On January 11, 2009, I built further positions given attractive valuations post the ascension in yields (SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS). The market moved in my favor last week. Overall, the results are mixed.
I am still overweight Indian bonds because supply is really not an issue, in my view. Slackening private investment demand will create space for government bonds on bank balance sheets. I am also expecting the Reserve bank to reduce the reverse repo rate by at least 50bp in H1 2009
Now I will cover trades that made me money.
2. Long U.S. Dollar: Long USD/INR up 2.5% and long UUP up 2.9%. I shorted the INR versus the dollar on December 22, 2008 (INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER). The INR has weakened 2.5% since then (47.38 on December 22, 2008 to 48.77 on January 19, 2009). I bought UUP (DXY) on December 29, 2008 (TACTICAL NOTES FOR EARLY 2009). The U.S. dollar has gained ground in the first half of January. As discussed in the rationale for the trade, global central banks followed the Fed in the march toward ZIRP in early 2009. The end of the risk rally also helped the dollar.
3. Long U.S. Credit: Long HYG (U.S. high-yield) up 0.9% and LQD (U.S. Investment-Grade) up 1.0% (TACTICAL NOTES FOR EARLY 2009). The correct way to gauge the performance of spread products is after adjusting for returns from duration matched treasuries. I shall not make that adjustment because I consciously assumed duration exposure in addition to spread risk. Bear in mind, however, that TLH (10-20 year treasury ETF) is down 2.3% during the same period, underscoring the out-performance of corporate paper.
4. Long U.S. 10-year break-even inflation: (Long TIP versus TLH) up 1.6% (TACTICAL NOTES FOR EARLY 2009): 10-year breakevens are about 40bp wider now. Also, 5-year breakevens 5-year forward have gone up, but remain well below 2% - where the Fed seeks to anchor long-term inflationary expectations.
*******29-Dec-08**16-Jan-09***Change
TIP*****100.4******99.696******-0.7%
TLH*****122.68*****119.88******-2.3%
HYG*****75.29******75.99********0.9%
LQD*****100.58*****101.6********1.0%
UUP*****24.69******25.4*********2.9%
************22-Dec-08**19-Jan-09******Change
USD/INR******47.38******48.56**********2.5%
Source: MarketWatch;RBI
I will start with the trades with mixed results.
1. Long Indian bonds: I bought Indian bonds on December 14, 2008 (LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN). My prediction was that cash would outperform derivatives and within cash, I thought that a diversified basket of AAA corporate paper will swamp treasury returns. The market rallied. On December 28, 2008 (TACTICAL NOTES FOR EARLY 2009), I reiterated my buy call based on strong indications from authorities that rate cuts were imminent and that the likely easing was not priced in. The Reserve Bank cut the reverse repo rate by 100bp, but government securities sold off on fears of impending supply. On January 11, 2009, I built further positions given attractive valuations post the ascension in yields (SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS). The market moved in my favor last week. Overall, the results are mixed.
I am still overweight Indian bonds because supply is really not an issue, in my view. Slackening private investment demand will create space for government bonds on bank balance sheets. I am also expecting the Reserve bank to reduce the reverse repo rate by at least 50bp in H1 2009
Now I will cover trades that made me money.
2. Long U.S. Dollar: Long USD/INR up 2.5% and long UUP up 2.9%. I shorted the INR versus the dollar on December 22, 2008 (INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER). The INR has weakened 2.5% since then (47.38 on December 22, 2008 to 48.77 on January 19, 2009). I bought UUP (DXY) on December 29, 2008 (TACTICAL NOTES FOR EARLY 2009). The U.S. dollar has gained ground in the first half of January. As discussed in the rationale for the trade, global central banks followed the Fed in the march toward ZIRP in early 2009. The end of the risk rally also helped the dollar.
3. Long U.S. Credit: Long HYG (U.S. high-yield) up 0.9% and LQD (U.S. Investment-Grade) up 1.0% (TACTICAL NOTES FOR EARLY 2009). The correct way to gauge the performance of spread products is after adjusting for returns from duration matched treasuries. I shall not make that adjustment because I consciously assumed duration exposure in addition to spread risk. Bear in mind, however, that TLH (10-20 year treasury ETF) is down 2.3% during the same period, underscoring the out-performance of corporate paper.
4. Long U.S. 10-year break-even inflation: (Long TIP versus TLH) up 1.6% (TACTICAL NOTES FOR EARLY 2009): 10-year breakevens are about 40bp wider now. Also, 5-year breakevens 5-year forward have gone up, but remain well below 2% - where the Fed seeks to anchor long-term inflationary expectations.
*******29-Dec-08**16-Jan-09***Change
TIP*****100.4******99.696******-0.7%
TLH*****122.68*****119.88******-2.3%
HYG*****75.29******75.99********0.9%
LQD*****100.58*****101.6********1.0%
UUP*****24.69******25.4*********2.9%
************22-Dec-08**19-Jan-09******Change
USD/INR******47.38******48.56**********2.5%
Source: MarketWatch;RBI
Sunday, January 11, 2009
SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS
VICIOUS SELL-OFF IN INDIAN BONDS
The 10-year Government security yield rose from 5.25% on January 1, 2009 to close the week at 6.25%. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index rose 87bp from 8.11% on December 30, 2008. The 5-year OIS rates ascended to 4.94% from an all time low of 4.42% on January 2, 2009.
Real GDP growth will remain below trend not only in 2009 but also in 2010. Inflation will likely recede below 5%. Global central banks will maintain an easing bias in 2009. Given this backdrop, the Reserve Bank will cut the reverse repo rate by at least 50bp in the next 6-months. I view this sell-off as an opportunity. Risk free yields will decline, the curve will flatten and AAA corporate spreads will shrink significantly from current levels.
GLOBAL MONETARY CONVERGENCE CONTINUES: RISK IS OVER EASING TO COUNTERACT DYSFUNCTIONAL TRANSMISSION MECHANISM
The Bank of England reduced base rates by 50bp to 1.5% last week, the lowest level since 1694. Easing inflationary concerns imply that the ECB will follow suit sooner rather than later. The Fed’s minutes revealed a discussion on quantitative targets for preventing “deflationary dynamics”. The Bank of Korea slashed policy rates to 2.5%. Indonesia and Taiwan also cut by 50bp. Bottom-line, while there are signs that credit markets are unfreezing, big questions remain about the percolation of base liquidity into the broader economy. In all probability, monetary authorities will risk overshooting on the downside to counteract tighter lending standards and high spreads.
PERSISTENT EXCESS LIQUIDITY TO AID BONDS IN THE FACE OF A LARGE GOVERNMENT BORROWING PROGRAM
I predict consistently high reverse repo quantum in the foreseeable future. Please refer to my piece - LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN; December 14, 2008 - for details. The end-game will be a rising investment to deposit ratio. Despite rising issuance, slumping private investment demand will create space for government bonds in public sector bank balance-sheets.
10-YEAR GOVERNMENT BOND YIELD TO TRADE BELOW 5% EVEN WITHOUT FURTHER MONETARY EASING
In a scenario where the reverse repo rate remains at 4.0%, 1-year YTM (4.63% on January 9, 2009) will trade close to 4.10%. Low yields and large cash chests will lead to a chase for yield, resulting in shrinking term and credit spreads. The 1/10 spread closed Friday at 162bp and averaged 85bp since 2001. Based on data since 2001, the mean 1/10 spread measured slightly below 85bp when the 1-year yield-to-maturity set below 5.50% on average. These numbers emanate largely from 2002 and H1 2003 - a period characterized by economic circumstances not very different from the current reality. Thus, even without a rate cut I see the 10-year Government security yield falling below 5.00% in H1 2009. Most likely, there will be further cuts and 5.00% should be conclusively broken.
1-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 1/10 SPREAD
1YEAR YIELD***********1/10 Spread
4.00%-4.50%***********74bp
4.50%-5.00%***********77bp
5.00%-5.50%***********82bp
5.50%-6.00%***********111bp
6.00%-6.50%***********98bp
6.50%-7.00%***********99bp
7.00%-7.50%***********98bp
7.50%-8.00%***********38bp
8.00%-8.50%***********84bp
8.50%-9.00%***********89bp
9.00%-9.50%***********25bp
9.50%-10.00%***********91bp
HIGH QUALITY CORPORATE PAPER WILL OUTPERFORM TREASURIES IN 2009
The average yield on the FIMDA Bloomberg 10-year AAA corporate bond index averaged 106bp above 10-year Indian treasuries since December 2001. The current 10-year AAA corporate spread rests 2.4 sigma above the mean observed over the last 7-years. There is a high positive correlation between spreads (even in percentage terms) and the level of the yield curve measured by 10-year Government security yields. Bottom-line, the incremental return over treasuries will collapse significantly by the end of 2009.
10-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 10-YEAR AAA CORPORATE SPREAD
10YEAR YIELD***********AAA Spread
5.00%-6.00%************67bp
6.00%-7.00%************65bp
7.00%-8.00%************128bp
8.00%-9.00%************167bp
9.00%-10.00%***********154bp
TACTICALLY I AM SHIFTING MY ASSET ALLOCATION AWAY FROM EQUITIES TO BONDS
I view the current sell-off as an opportunity to build further long bond positions. The risk-reward from current yield and spread levels appears good. Also, I am reducing my equity index positions in light of continued bad economic news and possible downside surprises in the earnings season.
Bloomberg is the source for all the data used.
The 10-year Government security yield rose from 5.25% on January 1, 2009 to close the week at 6.25%. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index rose 87bp from 8.11% on December 30, 2008. The 5-year OIS rates ascended to 4.94% from an all time low of 4.42% on January 2, 2009.
Real GDP growth will remain below trend not only in 2009 but also in 2010. Inflation will likely recede below 5%. Global central banks will maintain an easing bias in 2009. Given this backdrop, the Reserve Bank will cut the reverse repo rate by at least 50bp in the next 6-months. I view this sell-off as an opportunity. Risk free yields will decline, the curve will flatten and AAA corporate spreads will shrink significantly from current levels.
GLOBAL MONETARY CONVERGENCE CONTINUES: RISK IS OVER EASING TO COUNTERACT DYSFUNCTIONAL TRANSMISSION MECHANISM
The Bank of England reduced base rates by 50bp to 1.5% last week, the lowest level since 1694. Easing inflationary concerns imply that the ECB will follow suit sooner rather than later. The Fed’s minutes revealed a discussion on quantitative targets for preventing “deflationary dynamics”. The Bank of Korea slashed policy rates to 2.5%. Indonesia and Taiwan also cut by 50bp. Bottom-line, while there are signs that credit markets are unfreezing, big questions remain about the percolation of base liquidity into the broader economy. In all probability, monetary authorities will risk overshooting on the downside to counteract tighter lending standards and high spreads.
PERSISTENT EXCESS LIQUIDITY TO AID BONDS IN THE FACE OF A LARGE GOVERNMENT BORROWING PROGRAM
I predict consistently high reverse repo quantum in the foreseeable future. Please refer to my piece - LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN; December 14, 2008 - for details. The end-game will be a rising investment to deposit ratio. Despite rising issuance, slumping private investment demand will create space for government bonds in public sector bank balance-sheets.
10-YEAR GOVERNMENT BOND YIELD TO TRADE BELOW 5% EVEN WITHOUT FURTHER MONETARY EASING
In a scenario where the reverse repo rate remains at 4.0%, 1-year YTM (4.63% on January 9, 2009) will trade close to 4.10%. Low yields and large cash chests will lead to a chase for yield, resulting in shrinking term and credit spreads. The 1/10 spread closed Friday at 162bp and averaged 85bp since 2001. Based on data since 2001, the mean 1/10 spread measured slightly below 85bp when the 1-year yield-to-maturity set below 5.50% on average. These numbers emanate largely from 2002 and H1 2003 - a period characterized by economic circumstances not very different from the current reality. Thus, even without a rate cut I see the 10-year Government security yield falling below 5.00% in H1 2009. Most likely, there will be further cuts and 5.00% should be conclusively broken.
1-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 1/10 SPREAD
1YEAR YIELD***********1/10 Spread
4.00%-4.50%***********74bp
4.50%-5.00%***********77bp
5.00%-5.50%***********82bp
5.50%-6.00%***********111bp
6.00%-6.50%***********98bp
6.50%-7.00%***********99bp
7.00%-7.50%***********98bp
7.50%-8.00%***********38bp
8.00%-8.50%***********84bp
8.50%-9.00%***********89bp
9.00%-9.50%***********25bp
9.50%-10.00%***********91bp
HIGH QUALITY CORPORATE PAPER WILL OUTPERFORM TREASURIES IN 2009
The average yield on the FIMDA Bloomberg 10-year AAA corporate bond index averaged 106bp above 10-year Indian treasuries since December 2001. The current 10-year AAA corporate spread rests 2.4 sigma above the mean observed over the last 7-years. There is a high positive correlation between spreads (even in percentage terms) and the level of the yield curve measured by 10-year Government security yields. Bottom-line, the incremental return over treasuries will collapse significantly by the end of 2009.
10-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 10-YEAR AAA CORPORATE SPREAD
10YEAR YIELD***********AAA Spread
5.00%-6.00%************67bp
6.00%-7.00%************65bp
7.00%-8.00%************128bp
8.00%-9.00%************167bp
9.00%-10.00%***********154bp
TACTICALLY I AM SHIFTING MY ASSET ALLOCATION AWAY FROM EQUITIES TO BONDS
I view the current sell-off as an opportunity to build further long bond positions. The risk-reward from current yield and spread levels appears good. Also, I am reducing my equity index positions in light of continued bad economic news and possible downside surprises in the earnings season.
Bloomberg is the source for all the data used.
Sunday, January 4, 2009
RBI EASES FURTHER; MORE ON THE WAY
NO SURPRISE
The Reserve Bank of India cut the reverse repo and the repo rate by 100bp each. The cash reserve ratio was reduced to 5.0% from 5.5%, releasing INR 200 billion of incremental liquidity.
ANOTHER ROUND OF CUTS LOOKS LIKELY
Even the optimists expect the global economy to bottom only in H2 2009. Indian manufacturing will remain hostage to poor export performance. Inter-sectoral linkages will pull the services sector down. Expect further cuts.
The Reserve Bank of India cut the reverse repo and the repo rate by 100bp each. The cash reserve ratio was reduced to 5.0% from 5.5%, releasing INR 200 billion of incremental liquidity.
ANOTHER ROUND OF CUTS LOOKS LIKELY
Even the optimists expect the global economy to bottom only in H2 2009. Indian manufacturing will remain hostage to poor export performance. Inter-sectoral linkages will pull the services sector down. Expect further cuts.
Sunday, December 28, 2008
TACTICAL NOTES FOR EARLY 2009
There is incredible amount of uncertainty. Any sustained recovery in risky assets looks unlikely in H1 2009. My preference remains for outlook neutral trades or investments that would benefit from incipient signs of a recovery but present minimal downside should such a scenario not materialize.
1. Long U.S. Credit: U.S. credit markets seem to be discounting economic cataclysm. Lehman’s U.S. Corporate Bond Index yields 7.66% (as of December 26, 2008; Source: WSJ) and the Baa sub-segment commands a YTM of 9.56% (versus 30-year and 10-year treasuries yielding just 2.60% and 2.14%, respectively). In comparison, Moody’s 30-year industrial spread measured 688bp in July 1932. The U.S. HY space seems priced for defaults exceeding the 3-year average rate observed during the great depression. The U.S. leveraged loan sector presents another compelling opportunity. Monetary policy remains focused on unfreezing credit markets and bringing interest rates down. In the event authorities fail, downside seems limited given already dire pricing. (long LQD and HYG)
2. Long U.S. Dollar: The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well. The INR will likely weaken above the 50 level over the next 6-months. Please refer to my previous piece for details: INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER. (long UUP)
3. Long 10-year U.S. TIPS versus treasuries: 10-year breakevens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage. (long TIP vs. TLH)
4. Long Indian bonds (both Government and corporate): The Reserve Bank of India will ease again. The reverse repo rate will be cut by at least 100bp over the next 1-year. The market does not seem to be discounting that outcome yet. Please refer to my previous piece for details: LONG BOND TRADE NOT DONE YET: EXPECT LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN.
1. Long U.S. Credit: U.S. credit markets seem to be discounting economic cataclysm. Lehman’s U.S. Corporate Bond Index yields 7.66% (as of December 26, 2008; Source: WSJ) and the Baa sub-segment commands a YTM of 9.56% (versus 30-year and 10-year treasuries yielding just 2.60% and 2.14%, respectively). In comparison, Moody’s 30-year industrial spread measured 688bp in July 1932. The U.S. HY space seems priced for defaults exceeding the 3-year average rate observed during the great depression. The U.S. leveraged loan sector presents another compelling opportunity. Monetary policy remains focused on unfreezing credit markets and bringing interest rates down. In the event authorities fail, downside seems limited given already dire pricing. (long LQD and HYG)
2. Long U.S. Dollar: The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well. The INR will likely weaken above the 50 level over the next 6-months. Please refer to my previous piece for details: INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER. (long UUP)
3. Long 10-year U.S. TIPS versus treasuries: 10-year breakevens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage. (long TIP vs. TLH)
4. Long Indian bonds (both Government and corporate): The Reserve Bank of India will ease again. The reverse repo rate will be cut by at least 100bp over the next 1-year. The market does not seem to be discounting that outcome yet. Please refer to my previous piece for details: LONG BOND TRADE NOT DONE YET: EXPECT LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN.
Sunday, December 21, 2008
INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER
THE END OR MERELY A BEND
The Indian rupee tanked 27% in the year to November 20, 2008 to reach an all time low of 50.12 versus the U.S. dollar. Over the last 30-days, the INR recovered about 6% to close at 47.05 on December 19. A key question is whether 2008 marks the end of the appreciation cycle that began in 2002.
In my view, the lofty INR levels seen in early 2008 will likely not be reached again over the next 5-years. The base case for the first half of 2009 is a retest of the 50 level. Beyond that, longer-term exchange rate expectations should remain geared to further weakness.
THE RESERVE BANK MANAGES THE CURRENCY IN THE CONTEXT OF A BROAD-BASED REAL EFFECTIVE EXCHANGE RATE; INDIAN RUPEE APPEARS FAIRLY VALUED
The RBI’s 36-country real effective exchange rate (1993-94 =100) fluctuated in a band of +/-5% over the last 16-years. In September 2008, the INR appeared undervalued by about 3.4%. In the period from September to December 19, the broad dollar index gained 6.5%, while the Indian rupee lost only 3.3%. The INR seems fairly valued right now and the future would crucially hinge on the direction of the U.S. dollar.
REVIVAL OF CAPITAL INFLOWS INTO EQUITY MARKETS WILL NOT TURN THE TIDE; THE RUPEE IS NOT AN INDIA STORY
The reversal of the INR’s fortunes coincided with portfolio capital outflows from equities. While the exchange rate continues to display high correlation with stocks, a sustained equity revival would not be accompanied by renewed rupee strength, in my view.
Instead, the outlook hinges on accurately forecasting the U.S. dollar. In 2008, the INR merely reflected the negative correlation between the U.S. dollar and risky asset performance. The dollar benefited from the status of treasuries as the ultimate risk free asset. Net private purchases of treasuries measured $253 billion in the 12 months to October 2008 versus $198 billion in 2007 and $126 billion in 2006. Additionally, with inter-bank dollar liquidity strained, it remained difficult to borrow and sell dollars. A natural conclusion seems to be that once the financial system stabilizes, the dollar slide will resume.
There is merit to this argument, but other developments underway suggest that a sustained recovery in risky assets will only mute the rise of the dollar, but not reverse the ascendancy.
THE U.S. CURRENT ACCOUNT DEFICIT IS CORRECTING; NEGATIVE WEALTH EFFECT CURBS CONSUMER SPENDING
After adjusting for crude oil imports, the U.S. trade deficit corrected by $85 billion during January-October 2008 compared to the same period last year. This trend will likely continue as declining housing and equity wealth force U.S. households to save. Restrained credit should also work to limit spending expansion.
NEAR-TERM DOLLAR VIEW SEEMS ECONOMY NEUTRAL
The Fed cut rates to 0%-0.25% (basically zero) last week. The U.S. authorities remain the most aggressive in providing policy stimulus. The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well.
THE BASE CASE: A U.S. LED GLOBAL RECOVERY COUPLED WITH DOLLAR STRENGTH
Global growth leadership outside the United States seems difficult to visualize. This point figures particularly pertinent in the face of the current account adjustment underway in the U.S. The last similar phase of U.S. current account adjustment stretched from 1987 to 1991. Rapidly growing Germany and Japan saved the day then. Such a state of affairs looks remote today.
Germany, Japan and China remain export-led. Other large current account deficit countries such as the U.K., Ireland and Spain suffer from their own housing busts. The best case for the global economy would be that extraordinary policy actions in the U.S. make the current account contraction more protracted. This would give the world more breathing room, enabling a feeble economic resurgence.
In this scenario, rate differentials will incrementally shift in the favor of the U.S. and that coupled with the dipping trade deficit will propel the dollar higher.
INFLATION TAIL OUTCOME MORE LIKELY THAN DEFLATION
What if monetary policy remains ineffective? With the financial system clogged, there is a positive probability that substantial base liquidity does not percolate into the system. In this low likelihood scenario, policy makers in the U.S. would prefer inflation to deflation. In a debt laden economy, there is really no choice. The Fed will continue undertaking unconventional policy actions to stoke inflationary expectations. Large monetized budget deficits would be the natural course to pursue. It is hard to imagine how other democratic governments will defend tight policy in the face of large scale job losses. The winners will be gold and hard assets in this scenario.
RISK REWARD NOT GREAT FOR USD/INR SHORTS
If the broad dollar index remains unchanged for the next 5-years, the INR will depreciate in line with inflation differentials – about 3% per year. More likely, generalized greenback strength will cause losses more than 3% per year.
In light of the above, for strategic short USD/INR trades; it seems more like the end of the road.
The Indian rupee tanked 27% in the year to November 20, 2008 to reach an all time low of 50.12 versus the U.S. dollar. Over the last 30-days, the INR recovered about 6% to close at 47.05 on December 19. A key question is whether 2008 marks the end of the appreciation cycle that began in 2002.
In my view, the lofty INR levels seen in early 2008 will likely not be reached again over the next 5-years. The base case for the first half of 2009 is a retest of the 50 level. Beyond that, longer-term exchange rate expectations should remain geared to further weakness.
THE RESERVE BANK MANAGES THE CURRENCY IN THE CONTEXT OF A BROAD-BASED REAL EFFECTIVE EXCHANGE RATE; INDIAN RUPEE APPEARS FAIRLY VALUED
The RBI’s 36-country real effective exchange rate (1993-94 =100) fluctuated in a band of +/-5% over the last 16-years. In September 2008, the INR appeared undervalued by about 3.4%. In the period from September to December 19, the broad dollar index gained 6.5%, while the Indian rupee lost only 3.3%. The INR seems fairly valued right now and the future would crucially hinge on the direction of the U.S. dollar.
REVIVAL OF CAPITAL INFLOWS INTO EQUITY MARKETS WILL NOT TURN THE TIDE; THE RUPEE IS NOT AN INDIA STORY
The reversal of the INR’s fortunes coincided with portfolio capital outflows from equities. While the exchange rate continues to display high correlation with stocks, a sustained equity revival would not be accompanied by renewed rupee strength, in my view.
Instead, the outlook hinges on accurately forecasting the U.S. dollar. In 2008, the INR merely reflected the negative correlation between the U.S. dollar and risky asset performance. The dollar benefited from the status of treasuries as the ultimate risk free asset. Net private purchases of treasuries measured $253 billion in the 12 months to October 2008 versus $198 billion in 2007 and $126 billion in 2006. Additionally, with inter-bank dollar liquidity strained, it remained difficult to borrow and sell dollars. A natural conclusion seems to be that once the financial system stabilizes, the dollar slide will resume.
There is merit to this argument, but other developments underway suggest that a sustained recovery in risky assets will only mute the rise of the dollar, but not reverse the ascendancy.
THE U.S. CURRENT ACCOUNT DEFICIT IS CORRECTING; NEGATIVE WEALTH EFFECT CURBS CONSUMER SPENDING
After adjusting for crude oil imports, the U.S. trade deficit corrected by $85 billion during January-October 2008 compared to the same period last year. This trend will likely continue as declining housing and equity wealth force U.S. households to save. Restrained credit should also work to limit spending expansion.
NEAR-TERM DOLLAR VIEW SEEMS ECONOMY NEUTRAL
The Fed cut rates to 0%-0.25% (basically zero) last week. The U.S. authorities remain the most aggressive in providing policy stimulus. The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well.
THE BASE CASE: A U.S. LED GLOBAL RECOVERY COUPLED WITH DOLLAR STRENGTH
Global growth leadership outside the United States seems difficult to visualize. This point figures particularly pertinent in the face of the current account adjustment underway in the U.S. The last similar phase of U.S. current account adjustment stretched from 1987 to 1991. Rapidly growing Germany and Japan saved the day then. Such a state of affairs looks remote today.
Germany, Japan and China remain export-led. Other large current account deficit countries such as the U.K., Ireland and Spain suffer from their own housing busts. The best case for the global economy would be that extraordinary policy actions in the U.S. make the current account contraction more protracted. This would give the world more breathing room, enabling a feeble economic resurgence.
In this scenario, rate differentials will incrementally shift in the favor of the U.S. and that coupled with the dipping trade deficit will propel the dollar higher.
INFLATION TAIL OUTCOME MORE LIKELY THAN DEFLATION
What if monetary policy remains ineffective? With the financial system clogged, there is a positive probability that substantial base liquidity does not percolate into the system. In this low likelihood scenario, policy makers in the U.S. would prefer inflation to deflation. In a debt laden economy, there is really no choice. The Fed will continue undertaking unconventional policy actions to stoke inflationary expectations. Large monetized budget deficits would be the natural course to pursue. It is hard to imagine how other democratic governments will defend tight policy in the face of large scale job losses. The winners will be gold and hard assets in this scenario.
RISK REWARD NOT GREAT FOR USD/INR SHORTS
If the broad dollar index remains unchanged for the next 5-years, the INR will depreciate in line with inflation differentials – about 3% per year. More likely, generalized greenback strength will cause losses more than 3% per year.
In light of the above, for strategic short USD/INR trades; it seems more like the end of the road.
Sunday, December 14, 2008
LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN
MASSIVE DECLINE IN YIELDS BOTH IN CASH AND DERIVATIVE SEGMENTS
The 10-year Government security yield fell to 6.16% on December 12, 2008 from a high of 9.47% established in July 2008. 5-year OIS rates declined 548bp to 4.88% from the peak set in June 2008. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index descended to 8.95% from the crest on November 11, 2008. The growth-inflation picture for 2009 suggests that the long bond trade will continue to deliver returns in the foreseeable future.
EXPECT BELOW POTENTIAL INDIAN GROWTH IN 2009 AND 2010
U.S., Europe, and Japan remain in a recession. Sharply slowing export data (-2.2% in November 2008) from China point to lower growth in times ahead. Consensus expects a tepid global recovery in the second half of 2009 at the earliest.
Indian industrial production numbers for October 2008 registered a 0.4% y/y decline. While the Indian economy is relatively closed with exports/GDP of just around 20%, the secondary sector depends on global demand to a large extent. Manufacturing expansion in 2009 will be challenged by underperformance of external spending. And services will not be immune due to inter-sectoral linkages (Sustainability of Services-Led Growth: An Input Output Analysis of the Indian Economy; 2003 RBI Occasional Papers). Capex will be the next casualty as capacity utilization falls. Bottom-line, 8% real GDP growth will not be seen for at least the next couple of years. Expect readings in the vicinity of 5% instead.
INFLATION TO AVERAGE SUB-5% IN 2009 AND 2010
Although headline WPI and various measures of CPI appear elevated, the outlook figures positive in view of weak world expansion prospects and the substantial decline in commodity prices. International factors drove bulk of the local price escalation over the last 4-years, with the largest contribution coming from fuel and metals. The Baltic Dry Index fell off the cliff in 2008, as did the CRB index. Resurgence looks unlikely in the foreseeable future.
BELOW POTENTIAL GROWTH AND SUBDUED INFLATION = AGGRESSIVE MONETARY EASING
How much of a difference six months can make! Global central banks quickly changed gears from fighting inflation to supporting aggregate demand. The Fed will cut to 0.5% in the coming week. The effective Fed Funds rate remains firmly below target due to quantitative easing. The ECB and BOE will maintain their aggressive easing bias. Monetary authorities will probably over ease to prevent deflationary expectations from taking hold and to counter de-levering induced bloated risk-spreads.
The RBI also acted with alacrity to reduce borrowing costs. Expect more of the same. The Reserve Bank will likely cut the reverse repo rate by at least 100bp over the next 6-months.
PERSISTENT EXCESS LIQUIDITY TO BE THE NORM
The quantum channel of monetary policy retains importance in India. The RBI will keep the economy flushed with money. Additionally, assuming an incremental capital output ratio of 4, a 5%-6% real expansion will require funding of the order of 20%-25% of GDP. The domestic savings rate of plus 30%, clearly in excess of the economy’s absorptive capacity; will adjust lower in a dis-inflationary fashion. The process will manifest in the banking system in form of high time deposit growth and slowing non-food credit ascension. The result – enduring excess deployable funds. The call rate will hug the reverse repo as a result. The end-game would be an increasing investment to deposit multiple. The combination of low yields, excess liquidity and a positive rate outlook would trigger a chase for yield leading to lower term and credit spreads.
YIELDS WILL CONTINUE TO SLIDE
In the scenario outlined above, sub-4% 5-year OIS rate is a clear possibility. Yet going forward, most of the rally will manifest in the cash segment. The previous low for the 10-year Government security yield (4.94% in 2003) will most likely be broken.
MOST OF THE OPPORTUNITY LIES IN CORPORATE BONDS
The maximum upside trade would be going long a diversified basket (with issuer due diligence) of AAA corporate bonds. Nominal spreads over treasuries on FIMMDA Bloomberg 10-year AAA corporate bond index descended to 279bp from 416bp on November 6, 2008. The average yield over term-matched local treasuries since December 5, 2001 measures 105bp. Clearly, there is still a lot of room for price appreciation in high quality corporate paper.
To summarize, despite a significant decrement in yields already; the economic outlook suggests still more downside. The risk reward appears better for cash bonds versus swaps. Within the cash segment, high quality corporate bonds would reward fixed income portfolios most in the times ahead.
The 10-year Government security yield fell to 6.16% on December 12, 2008 from a high of 9.47% established in July 2008. 5-year OIS rates declined 548bp to 4.88% from the peak set in June 2008. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index descended to 8.95% from the crest on November 11, 2008. The growth-inflation picture for 2009 suggests that the long bond trade will continue to deliver returns in the foreseeable future.
EXPECT BELOW POTENTIAL INDIAN GROWTH IN 2009 AND 2010
U.S., Europe, and Japan remain in a recession. Sharply slowing export data (-2.2% in November 2008) from China point to lower growth in times ahead. Consensus expects a tepid global recovery in the second half of 2009 at the earliest.
Indian industrial production numbers for October 2008 registered a 0.4% y/y decline. While the Indian economy is relatively closed with exports/GDP of just around 20%, the secondary sector depends on global demand to a large extent. Manufacturing expansion in 2009 will be challenged by underperformance of external spending. And services will not be immune due to inter-sectoral linkages (Sustainability of Services-Led Growth: An Input Output Analysis of the Indian Economy; 2003 RBI Occasional Papers). Capex will be the next casualty as capacity utilization falls. Bottom-line, 8% real GDP growth will not be seen for at least the next couple of years. Expect readings in the vicinity of 5% instead.
INFLATION TO AVERAGE SUB-5% IN 2009 AND 2010
Although headline WPI and various measures of CPI appear elevated, the outlook figures positive in view of weak world expansion prospects and the substantial decline in commodity prices. International factors drove bulk of the local price escalation over the last 4-years, with the largest contribution coming from fuel and metals. The Baltic Dry Index fell off the cliff in 2008, as did the CRB index. Resurgence looks unlikely in the foreseeable future.
BELOW POTENTIAL GROWTH AND SUBDUED INFLATION = AGGRESSIVE MONETARY EASING
How much of a difference six months can make! Global central banks quickly changed gears from fighting inflation to supporting aggregate demand. The Fed will cut to 0.5% in the coming week. The effective Fed Funds rate remains firmly below target due to quantitative easing. The ECB and BOE will maintain their aggressive easing bias. Monetary authorities will probably over ease to prevent deflationary expectations from taking hold and to counter de-levering induced bloated risk-spreads.
The RBI also acted with alacrity to reduce borrowing costs. Expect more of the same. The Reserve Bank will likely cut the reverse repo rate by at least 100bp over the next 6-months.
PERSISTENT EXCESS LIQUIDITY TO BE THE NORM
The quantum channel of monetary policy retains importance in India. The RBI will keep the economy flushed with money. Additionally, assuming an incremental capital output ratio of 4, a 5%-6% real expansion will require funding of the order of 20%-25% of GDP. The domestic savings rate of plus 30%, clearly in excess of the economy’s absorptive capacity; will adjust lower in a dis-inflationary fashion. The process will manifest in the banking system in form of high time deposit growth and slowing non-food credit ascension. The result – enduring excess deployable funds. The call rate will hug the reverse repo as a result. The end-game would be an increasing investment to deposit multiple. The combination of low yields, excess liquidity and a positive rate outlook would trigger a chase for yield leading to lower term and credit spreads.
YIELDS WILL CONTINUE TO SLIDE
In the scenario outlined above, sub-4% 5-year OIS rate is a clear possibility. Yet going forward, most of the rally will manifest in the cash segment. The previous low for the 10-year Government security yield (4.94% in 2003) will most likely be broken.
MOST OF THE OPPORTUNITY LIES IN CORPORATE BONDS
The maximum upside trade would be going long a diversified basket (with issuer due diligence) of AAA corporate bonds. Nominal spreads over treasuries on FIMMDA Bloomberg 10-year AAA corporate bond index descended to 279bp from 416bp on November 6, 2008. The average yield over term-matched local treasuries since December 5, 2001 measures 105bp. Clearly, there is still a lot of room for price appreciation in high quality corporate paper.
To summarize, despite a significant decrement in yields already; the economic outlook suggests still more downside. The risk reward appears better for cash bonds versus swaps. Within the cash segment, high quality corporate bonds would reward fixed income portfolios most in the times ahead.
Subscribe to:
Posts (Atom)