Subsequent to the confirmation by the US Fed that Tapering of Asset Purchases is going to be a reality now we saw the markets sell of sharply. Even prior to the event I had written in my last article that we should not fear FED Tapering but welcome it. The main logic’s being that firstly it will happen if the US Fed believes that the economy in the US is now on a self sustaining upmove and secondly because a strong USD traditionally has been negative for commodities and as such the inflation driven by high commodity prices should moderate. Lower to stable commodity prices will ultimately be also positive for a country like India as it will substantially reduce India’s CAD over the long term.As I had written earlier, only traders need to be worried about the Tapering and that is what transpired. Markets sold off post the tapering announcement before regaining all the losses over the last few trading sessions.However the other big side affect post FED announcement has been the sell off in most currencies versus the USD. This has been even more prominent for emerging market currencies, especially those which have a high CAD. As such we have seen that the INR has fallen by nearly 12% over the last two months, first in anticipation of the Tapering and then after the actual event. The fall has got accelerated due to the sell off in Indian Bonds which has bought to light the deficiencies in the short term policies of the RBI and the Government of India which did not use the extremely low yields and strong market liquidity right from third quarter of last year to the first quarter of 2013 for raising a Sovereign Bond. They made the entry of more and more short term FII flows into Government bonds easier and easier. As we have always seen that short term fixes have adverse affects and as a result we have already seen a nearly $ 8 billion flow out of Indian Government Bonds. If the same money had been raised via a sovereign bond issue at a yield of just around 3.5% (when the US 10 year was trading at 1.5%) we would have been much better off. The Forex reserves would have moved up sustain-ably and the country would have locked in long term USD money at cheap borrowing levels. The bond sell off by FII’s in the domestic market would not have transpired and as a result the sell off in the INR would also have been much more moderate. Today US 10 yr bonds yield 2.7%, just 0.8% below what India could have borrowed at just 3-6 months back.Subsequently we had a few days where some of the usual suspects created a flutter in the market and the markets sold off on some political issues in Portugal and also some issues that the Trioka of lenders were facing with Greece. However as we have seen not several but tens of time in the past such issues normally create volatility but cannot change the trend. As such these fears have turned out to be just that and in my view will remain the same in the future too.The one big change that came out of the policy meeting of the European Central Bank was that they gave a long term direction which they normally never do. Subsequent comments of ECB officials have also been quite dovish and this combined with the extremely dovish stance of the Bank of Japan today creates a situation where the long term direction of the USD seems to be turning up and in a strong manner. This move now has implications in terms of creating a weakness in other currencies versus the USD. However the one key difference in thought between the arm chair economists and reality is that currencies will follow the direction of economic growth outlook and not interest rates. Raising interest rates in order to strengthen the currency or keeping rates high is the traditional thought process. However it is only a short term fix. The longer term fix for the currency is to improve the growth prospects. There is no shortage of liquidity in the world and despite the panic created around FED Tapering there is unlikely to be a global liquidity shortage anytime over the next three years atleast. The reasons are simple to understand.-The FED is going to Taper purchases, not sell assets in the markets. As such additional liquidity is still getting generated.-Money printing by the BOJ just started six months back and will go on for atleast two more years-The ECB has indicated very low rates for the foreseeable future. This will also keep Euro liquidity strong.The important thing then is to create an opportunity for this liquidity to get gainfully deployed in your economy. For this the government needs to revive the investment cycle and boost foreign investor confidence. There are some indications that the governemtn wants to move in this direction, however given that they have spend four years going the other way it will still take some more time. The worst impact of the weak currency is that it increases inflation without an increased demand. We have already had two major depreciation cycles in the last three years. We clearly need the currency to stabilize if growth has to revive. However responses like reducing bank trading positions, increasing margins, making foreign borrowings easier are just short term fixes and that is what the government and regulators are doing right now.Interesting Chart formationsOver the last couple of years I have tracked the bonds and markets of Spain and Italy as two markets that have given lead indicators for other markets. Easing bond yields and reduction in fear in the bonds of these two countries has been positive for equity markets. Lately I have observed interesting chart patterns in the equity markets of both these countries. These mirror the way the markets were before the big bull phase started in the year 2004. Sometimes historical patterns do repeat as we saw in the case of gold. Lets see how it plays out for the equity markets. Subsequent to the confirmation by the US Fed that Tapering of Asset Purchases is going to be a reality now we saw the markets sell of sharply. Even prior to the event I had written in my last article that we should not fear FED Tapering but welcome it. The main logics being that firstly it will happen if the US Fed believes that the economy in the US is now on a self sustaining upmove and secondly because a strong USD traditionally has been negative for commodities and as such the inflation driven by high commodity prices should moderate. Lower to stable commodity prices will ultimately be also positive for a country like India as it will substantially reduce India’s CAD over the long term.As I had written earlier, only traders need to be worried about the Tapering and that is what transpired. Markets sold off post the tapering announcement before regaining all the losses over the last few trading sessions.However the other big side affect post FED announcement has been the sell off in most currencies versus the USD. This has been even more prominent for emerging market currencies, especially those which have a high CAD. As such we have seen that the INR has fallen by nearly 12% over the last two months, first in anticipation of the Tapering and then after the actual event. The fall has got accelerated due to the sell off in Indian Bonds which has bought to light the defeciencies in the short term policies of the RBI and the Government of India which did not use the extremely low yields and strong market liquidity right from third quarter of last year to the first quarter of 2013 for raising a Sovereign Bond. They made the entry of more and more short term FII flows into Government bonds easier and easier. As we have always seen that short term fixes have adverse affects and as a result we have already seen a nearly $ 8 billion flow out of Indian Government Bonds. If the same money had been raised via a sovereign bond issue at a yield of just around 3.5% (when the US 10 year was trading at 1.5%) we would have been much better off. The Forex reserves would have moved up sustainably and the country would have locked in long term USD money at cheap borrowing levels. The bond sell off by FII’s in the domestic market would not have transpired and as a result the sell off in the INR would also have been much more moderate. Today US 10 yr bonds yield 2.7%, just 0.8% below what India could have borrowed at just 3-6 months back.Subsequently we had a few days where some of the usual suspects created a flutter in the market and the markets sold off on some political issues in Portugal and also some issues that the Trioka of lenders were facing with Greece. However as we have seen not several but tens of time in the past such issues normally create volatility but cannot change the trend. As such these fears have turned out to be just that and in my view will remain the same in the future too.The one big change that came out of the policy meeting of the European Central Bank was that they gave a long term direction which they normally never do. Subsequent comments of ECB officials have also been quite dovish and this combined with the extremely dovish stance of the Bank of Japan today creates a situation where the long term direction of the USD seems to be turning up and in a strong manner. This move now has implications in terms of creating a weakness in other currencies versus the USD. However the one key difference in thought between the arm chair economists and reality is that currencies will follow the direction of economic growth outlook and not interest rates. Raising interest rates in order to strengthen the currency or keeping rates high is the traditional thought process. However it is only a short term fix. The longer term fix for the currency is to improve the growth prospects. There is no shortage of liquidity in the world and despite the panic created around FED Tapering there is unlikely to be a global liquidity shortage anytime over the next three years atleast. The reasons are simple to understand.-The FED is going to Taper purchases, not sell assets in the markets. As such additional liquidity is still getting generated.-Money printing by the BOJ just started six months back and will go on for atleast two more years-The ECB has indicated very low rates for the foreseeable future. This will also keep Euro liquidity strong.The important thing then is to create an opportunity for this liquidity to get gainfully deployed in your economy. For this the government needs to revivie the investment cycle and boost foreign investor confidence. There are some indications that the governemtn wants to move in this direction, however given that they have spend four years going the other way it will still take some more time. The worst impact of the weak currency is that it increases inflation without an increased demand. We have already had two major depreciation cycles in the last three years. We clearly need the currency to stabilize if growth has to revive. However responses like reducing bank trading positons, increasing margins, making foreign borrowings easier are just short term fixes and that is what the government and regulators are doing right now.Interesting Chart formationsOver the last couple of years I have tracked the bonds and markets of Spain and Italy as two markets that have given lead indicators for other markets. Easing bond yields and reduction in fear in the bonds of these two countries has been positive for equity markets. Lately I have observed interesting chart patterns in the equity markets of both these countries. These mirror the way the markets were before the big bull phase started in the year 2004. Sometimes historical patterns do repeat as we saw in the case of gold. Lets see how it plays out for the equity markets.SPAIN IBEX WEEKLY CHART ITALY FTSE MIBMarketsWe are now at the beginning of the results season. Expectations are low and the the overall results season should be subdued and factored into the markets. The key is the economic growth outlook from here on. We have seen several brokerage downgrades over the last few weeks on India’s economic growth outlook. However it seems that they are turning pessimistic at the wrong time as they turned optimistic too early. The benefits of a normal and well spread out monsoon combined with strong government spending seem to be getting ignored. Even with a subdued investment cycle a 6% growth seems probable. Some sort of investment revival in the second half could also aid growth. However on the other hand, currency depreciation and its resultant impact on inflation wil reduce the pace of decline in interest rates and delay recovery. Overall it seems to be a mixed bag at this stage. The key will be to see where the INR stabilizes after the spiked sell off seen recently. Export oriented sectors like IT and Pharmaceuticals that are obvious beneficiaries of the currency move have remained strong whereas economy linked sectors have underperformed since the depreciation cycle started.Both Emerging Markets and EM currencies seem to be heavily oversold and due for a strong bounce back. However the drivers for a strong trend change seem to be missing at this stage. Maybe we will need to wait for 2014 for a bigger market move. Lets hope it happens earlier.
