Central banks have won Round 1 in their fight against credit crunch. The first couple of days of trading in the new year saw a fall in interbank lending rates, now that the end of the year demand for holding cash has evaporated. The London interbank offered rate (Libor), the interest rate at which banks borrow from each other, fell to 4.54% for one-month dollars last Thursday, 29 basis points more than the Fed funds target rate of 4.25%, while three-month dollar Libor was at 4.65%, 40 basis points more than the Fed funds rate.
A month ago, when the Fed funds rate was 4.5%, one-month dollar Libor was at 74 basis points over that rate, while three-month dollar Libor was 63 basis points above it. In fact, both the one-month and three-month dollar Libor rates are now at a lower premium to the Fed funds rate than they used to be three months ago.
Similar trends are seen in both the sterling and the euro Libor rates. It’s very clear, therefore, that the massive doses of liquidity injected by the central banks have worked.
That should be a source of great comfort to investors. To be sure, these liquidity injections are temporary, but central banks have left little doubt that they’re willing to do whatever it takes to ensure that the credit markets do not seize up. What’s more, it’s probable that concerns about bank lending being affected are overblown, with US bank credit continuing to grow at a decent pace. While some sectors, such as the mortgage origination market, are likely to be affected, there is little evidence so far of a general contraction in credit.
That’s good news on the liquidity front. One of the worries about the credit crisis has been that it will lead to a contraction in market liquidity, as banks pull back credit. That doesn’t seem to be happening.
Also, the asset-backed commercial paper market is showing signs of life, with the largest increase in issuance in seven years in the week to 2 January. On the other hand, concerns about a slowdown in the US economy are not likely to go away in a hurry. That should pave the way for a rate cut, which, combined with the easier credit conditions, should see another wave of liquidity being unleashed.
The markets also do not believe that the threat of inflation will prevent another rate cut by the US Federal Reserve, in spite of oil at near $100 (Rs3,950) a barrel, rising food prices and a falling dollar. Fed fund futures are already pricing in a 100% probability of a 25 basis?point rate cut at the next meeting of the Federal Open Market Committee on 29-30 January and about a 60% chance of a 50 basis point rate cut. The big question is: where will all the liquidity go? At the moment, it’s going into oil and gold.
The outperformance of mid- and small-cap shares is nothing new for the Indian markets. These segments have consistently beaten large-cap peers in terms of returns since the beginning of the current bull run that started in 2003.
The Bombay Stock Exchange’s mid- and small-cap indices were launched only in April 2005. Even the National Stock Exchange’s current Midcap index was launched in mid-2005, but it has back-dated data on the index, which shows that smaller-sized shares have led the rally right at its outset (see chart). In fact, in just a little over three months from the beginning of the rise in share prices, the CNX Midcap index had outperformed the Nifty by about 30%.
The level of outperformance peaked in September 2005 at 67.5%, which is interesting because it preceded a 13% correction in the markets within a month. Similarly, in May 2006, just before the markets corrected by about 30%, the Midcap index had outperformed the Nifty by 57% as measured from the beginning of the rally in April 2003. Ever since the correction that lasted till mid-June 2006, large-cap stocks did better, until the current euphoria surrounding small-sized shares. At last count, the level of outperformance stands at 69%, up substantially from around the 39% level just two months ago.
This is the highest level of outperformance the CNX Midcap index has achieved since the rally began in 2003. The flip side is that when the correction comes, these stocks will have a longer way to fall.
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