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An uncertainty premium on bonds

An uncertainty premium on bonds
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First Published: Mon, Sep 24 2007. 01 07 AM IST

Updated: Mon, Sep 24 2007. 01 07 AM IST
Here’s a strange conundrum: interest-rate sensitive stocks have rallied since the rate cut by the US Federal Reserve, the rupee has gone up to nine-year highs against the dollar, but bond yields have hardly moved. The yield on the 10-year bond was in the range of 7.882-7.886% on 18 September, just before the US rate cut, and the yield softened to 7.858-7.868% on Friday morning.
There seems to be a disconnect between the view taken by the stock market and the foreign exchange market about the rate cut and the view taken by the local bond market. The strange thing is that this has happened in spite of very low inflation.
There are several reasons for the divergence. One of them could be the advance tax outflow, which is a temporary factor. Another could be the fact that yields on long-term treasuries in the US have actually gone up after the Fed rate cut, because of fears about inflation on the one hand and on account of bonds losing their safe haven status on the other.
But the most important reason, as HDFC Bank Ltd chief economist Abheek Barua points out, is that there’s a lot of uncertainty about the Reserve Bank of India’s (RBI’s) view on interest rates in India, and this uncertainty premium is being built into bond yields.
There are plenty of reasons for RBI to be cautious, the most important of which are high international crude oil and food prices. RBI’s annual report held out little hope of an early rate cut. Moreover, now that large capital inflows have resumed, the central bank will have to make up its mind on whether to allow the rupee to appreciate and take the edge off higher crude prices, or whether to intervene in the forex market, which could lead to higher domestic liquidity.
It chose the second course in July by mopping up more than $11 billion (Rs43,890 crore), but then it had to raise the cash reserve ratio at the end of the month. Spreads on emerging market paper have also tightened sharply and borrowing abroad continues to be very attractive. That’s why foreign institutional investor and external commercial borrowing flows could once again prove to be a headache for RBI. But with HDFC indicating that home loan rates would be lowered, the rally in interest-rate sensitive stocks could well sustain.
Complacency already?
The Indian markets have become much more savvy in their use of index derivatives for protecting risk during volatile times. Till only a couple of years ago, stock futures dominated trades done in the derivatives market. But when the markets corrected last May and June, the share of index derivatives jumped to 47.5%, from under 34% in the previous two months. Since then, index futures and options (read Nifty, the rest of the lot are hardly traded) have accounted for about 45% of the derivatives market.
The proportion varies from time to time, depending on the state of the market— when the markets are rising, traders prefer placing their bets using stock futures, but in times of uncertainty or when the markets are falling, they latch on to index products for hedging and for taking bets on the broad market. Thus, when the markets corrected in February and March this year, the share of index derivatives in total turnover jumped to 53%.
But their share continued to decline as the markets started to rise from mid-March. By July, when the markets peaked, the share of index products had dropped to less than 33%. But during the period of correction in August, their share jumped to 48%.
Interestingly, index derivatives have accounted for just 35.6% of turnover this month. In the past two trading sessions, the share has dropped to less than 30%, with stock futures enjoying nearly two-thirds of the total turnover. While it may be presumptuous to say that traders are throwing caution to the winds based only on the above data, it can be seen as a sign of complacency setting in.
Write to us at marktomarket@livemint.com
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First Published: Mon, Sep 24 2007. 01 07 AM IST