<b>Abheek Barua:</b> Is the worst over for the markets?

While the macroeconomic situation could get much worse before it gets better, markets have aggressively priced this in.

The Sensex gained a fair bit over the past fortnight as did the rupee, pulling back from levels over 50 to the dollar all the way up to 47. We were not alone — all Asian stock markets rallied as did their currencies. The Korean won (that has correlated strongly with the rupee over the past few months) gained 11 per cent in December on the back of a gain of 11.5 per cent in the South Korean stock-index, the KOSPI. In fact, almost all non-dollar assets rallied. The euro, which most analysts had predicted was on a way ride towards parity against the greenback, rallied by 10 per cent from the beginning of December, trading at about 1.4 on December 19. The exception was oil which, after a brief rally, plummeted to new lows.

It would be rational, given recent experience, to dismiss this rally as just another snap-back in the midst of a bear market decline that is likely to be temporary. That could well be the case, given that global and domestic macroeconomic fundamentals seem to be getting worse. For one, macro-data, both for India and the global economy, has been printing below forecasted levels more often than not. However, it might be sensible to recognize some of the changes in financial market conditions that underpin the current reversal in asset prices. If these changes sustain, they might just be the initial sign of what technical analysts term a ‘bottom-formation’ in asset price. Thus even if the markets were to pare their current gains, prices could stabilize at levels that are somewhat higher than the previous fall. In short, the worst phase of the financial crisis could be over.

What are these changes? The most critical, I think, is the radical improvement in the inter-bank markets in the developed world. Inter-bank rates (LIBOR) are down to their pre-financial crisis levels. The spread between inter-bank rates and risk-free government bond yields (a common measure of risk) has also come down sharply from its October levels though it is below its pre-crisis levels. Some of the shorter-term credit markets have revived. Commercial paper issuance in the US, for instance, has picked up significantly.

This improvement could be the result of the massive amounts of liquidity that the US Fed and other central banks have pumped into the system, resulting in de-facto ‘quantitative easing’. The sharp cuts in policy rates have also paid off. (The US central bank just cut its target rate to a band of 0-0.25 per cent.) This has had some important ramifications for asset markets across the board. Most importantly, the improvement in the US inter-bank money markets has meant that US banks and financial institutions do not (at least temporarily) need to use non-dollar assets as a spigot of cash to make up for the lack of liquidity in their own money markets. The selling pressure on emerging market bonds and equities, for instance, has abated as a result of this. To use current jargon, ‘de-leveraging’ has taken a pause.

This thaw in credit markets has also meant that traders are going back to some of the more fundamental tenets of trading. Interest rate arbitrage that had taken a backseat in the desperate search for dollar liquidity has made a sort of comeback. The euro, for example, has gained because interest rates are higher in the eurozone (the benchmark policy rate of the European Central Bank is 2.5 per cent compared to 0-0.25 per cent in the US). Traders are now in a position to take advantage of the higher yields that Europe offers since trading is no longer focused on just generating as much dollar liquidity as possible.

Better liquidity conditions in the US have also revived risk appetite with one immediate result. Adverse news from the US is not leading to a mad flight to safety into US treasury assets. The dollar is being used a funding currency to invest in higher yielding assets like emerging market securities, not just as a safe haven.

Whether or not these changes sustain will determine the path that financial markets will tread over the coming years. Die-hard optimists claim that massive ‘de-leveraging’ is likely to have come to an end and this will provide a natural support to markets. As investors seek returns rather than safety, assets that were beaten down to a pulp will revive. Emerging markets that are putting expansionary fiscal policy in place and are less dependent on the US and Europe for demand will again ‘decouple’ from the rest of the world. Were this to happen, Indian markets could be on the road to recovery.

The pessimists, on the other hand, claim that there is a whole queue of party poopers waiting to ring the bell. Macroeconomic headlines and company results are likely to fall short of even the most conservative forecasts and that will set off another bout of acute risk aversion. The financial system could be in for another rude shock if, say, something like a crisis in the credit market were to emerge. Banks might find it extremely difficult to raise capital next year and sources of funding that were popular, like hybrid, are dead. Governments will borrow heavily in the markets to fund their bail-out programmes and could give private borrowers a run for their money. This could revive deleveraging-related selling pressure.

I am throwing my lot in with the optimists on this call. While I believe that the macroeconomic situation could get much worse before it gets better, I also recognize the fact the markets have been very aggressive in pricing these expectations in. A one-way recovery in the financial markets is unlikely and it is quite possible that the market will fall sharply again. However, the fact that the fall could be less deep and that the market is likely to find a higher bottom than the previous sell-off is not just an academic detail. It could just set the stage for a slow recovery in asset prices. The end of 2009 might bring much more cheer than its beginning.

The author is chief economist, HDFC Bank. The views here are personal