| Assuming people have put money where their mouths are, everybody has also done a lot of buying at that instant. Thus, according to the contrarians, there may actually be little demand left and the market could be ripe for profit-booking. |
| Does this adage hold true for the forex market? If so, given the high-decibel debate that the strong rupee has generated, it must now be close to a peak and due for a bout of weakness. Similarly, if the contrarian principle holds true for debt markets, interest rates must be ready to move South. |
| Bonds and forex are traded in totally institutional markets. In both markets, local macro-economic and global factors have a more direct impact on prices than is true for equity markets. While bonds and forex fluctuations reflect high levels of speculation, the speculation is less likely to be driven by irrational opinion and rumours. |
| The contrarian logic appears to be working at this moment in the forex markets. Public opinion overwhelmingly expects the rupee to rise further. However, the rupee has lost ground in the past month, dropping from Rs 40.27 on July 24 to Rs 41.18 on last Friday. It actually hit a low of 41.57 on August 17. |
| Most people (including senior members of the banking profession) think that the interest rate cycle is not yet at its peak. However, the institutional treasury bill market is usually a good lead indicator of rate direction and movements there suggest that rates may be close to peaking out. After hitting a peak YTM of 7.98 per cent on April 10, the 364-Day T-Bill dipped to 6.58 per cent in late July and, even after a recent firming up, it's trading at 7.49 per cent now. |
| Are these moves temporary blips which the wise trader will ignore? It's difficult to make a judgment call. But there are strong factors, which make it possible that the trends will be perpetuated for a little while at least. |
| The case for a weaker rupee is easy enough to state. The rupee appreciated from Rs 44 levels in January as a result of vast inflows on the portfolio account, which led to reserves hitting unheard-of levels. |
| India is running a trade deficit and a current account deficit. In the past month, the capital flows have been outwards. If the FII pare down India exposures a little further, the rupee may also depreciate a bit more. |
| The case for lower interest rates is more difficult to state. At one level, there has been a slowdown in credit offtake - Q1 bank credit growth dropped to (an admittedly impressive) 23 per cent from the previous three years' growth rate of 30 per cent. At another level, money supply is not being inflated by floods of incoming dollars and that has helped moderate inflation. So, one can make a case for domestic rates to stabilise at current levels. |
| If the rupee does depreciate and domestic rates do stabilise, India could see a soft landing from the asset bubble that built up over the past two years. Of course, there are push-pull factors. A weaker rupee will automatically push up inflation due to higher crude prices. Lower rates may also trigger new bursts of consumer spending. |
| But the trends of a weaker rupee and higher rates are no longer quite as clear as they seemed a month ago. That in turn obviously alters the perspective on equity. Dollar-earners get a boost and the much wider universe of rate-sensitive businesses also get a boost. If rates do ease off, the equity market could afford a higher PE ratio. |
| Right now, the Nifty is trading at an average 2006-7 PE of just under 19. That implies it is over-valued on a discount rate of over 5 per cent if we take EPS as a proxy for yield and invert the price-earnings relationship. Let's say that 2007-8 EPS will grow at 15 per cent, which was approximately the Q1 trend. The 2007-08 PE is then about 16.5 and the earnings yield about 6 per cent. That is close to fair-value if one is taking a reasonably optimistic perspective about rate direction. |
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