A question of interest

MARKET INSIGHT

Traders can follow a hedging strategy in the derivatives market to play the credit policy in bank stocks.

Will he or won't he? That's the question the entire financial community is asking. The "he" in question is Dr Reddy, governor of the RBI. The monetary policy is around the corner and bankers are tense about the prospects of another rate hike.

The data that would influence the decision is shaded in gray. Inflation was supposed to have eased off but the recent numbers suggest that it has started climbing again. On the other hand, there has been a drop in credit offtake, from around 30 per cent in the past couple of fiscals to about 24 per cent in the first quarter of 2007-08. And, out of other key indicators, the growth rate in housing loans has eased and real estate prices have seen some correction.

So you could argue that there has already been a cooling off. The enthusiasts for this viewpoint will also point to the fact that the inter-bank and call money rates have dropped to near-zero. So clearly, there isn't a liquidity problem.

However, central banks rarely have the luxury of making decisions on the basis of unambiguous data and trends. They also have access to information and aggregated data about the banking system, which is not in the public domain. Since this is a politically sensitive decision and the RBI is not an independent body the finance ministry's view on the subject is also a powerful factor.

Informed opinion on the subject is mixed. ABN Amro believes rates have peaked out, the J&K Bank's chairman and chief executive Haseeb Drabbu expects rates to rise another 50 basis points in two or three installments over the next six months. However, nobody seems to be expecting a cut "� the consensus varies between possible small hikes or status quo.

The political factor is unfathomable in the short-term but it must be bearish in the long-term. The current inflationary pressures and indeed, the inflationary pressures that triggered the hikes of the past 12 months were based on supply problems that the government lacks the power to alleviate.

Sooner or later, there will be another knee-jerk attempt to handle supply-side inflation through the medium of another interest hike. That may be economically absurd but it is the politically sane decision. At least the establishment is seen to be taking action even if the prescription doesn't fit the diagnosis.

Given expectations, I think the market would indulge in a relief rally if rates were not hiked. Such a rally would be focused on rate-sensitive sectors. Alternatively, a rate hike would mean a sell-off in rate-sensitive sectors such as financial services, banks and other lenders, real estate, automobiles and the like. I don't think that a 25 basis point hike would trigger a generalised sell-off though "rate-sensitive" does encompass a wide spectrum.

There has been massive institutional buying worldwide and a rate hike would not affect FII attitude much. Since a hike would probably accelerate rupee strengthening, hedge funds would come in hoping for appreciation on that account alone. Among Indian players, equity funds are sitting on cash-mountains which they must deploy and there is also a steady inflow of ULIP money that has to go somewhere. A rate hike would not therefore affect liquidity much, though it would mean a valuation downgrade.

Of course, if the RBI did cut rates, there would be a likely bullish explosion with the entire market being re-rated and the Nifty rising at least 5 per cent on the back of a 50-basis point cut. But a cut seems truly unlikely.

There has been little movement in bank shares over the past week. Next week could see larger swings in bank prices as the credit policy draws nearer. Next week also features the July derivative settlement. A trend in rate-sensitive stocks will only be clearly established after the policy is announced and absorbed.

How does one hedge in this situation? You could take a long position in the Bank Nifty and a short position in futures or buy a put of two or three heavyweight banks such as ICICI Bank, State Bank of India and Punjab National Bank. If you're long Bank Nifty, you gain a little from status quo (and a lot in the event of a cut). If you are also short bank futures or hold long bank puts, you may gain from a rate hike. Combining the two is a tricky exercise in practice. Toss a coin and skew your overall exposure in the indicated direction!