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Financial news: Lessons from the past

October 15, 2010 11:17 IST

When financial news hits the front page, do the opposite. I've been thinking about this aphorism over the past couple of weeks with the whole world - or, certainly, armies of global analysts - talking about "currency wars" and "beggar-thy-neighbour-as-thyself" policies.

Granted that this polished pearl of wisdom was perhaps more relevant in a time when financial markets were quite separate from the world of journalism - a far cry from today's live-time focus on markets. But I think it's still relevant today.

Let us look at what's been happening in the forex (FX) market. Since the start of the year, the dollar index (DXY) rose to a high of almost 90 on the back of a continuing flight of capital to the supposed safety of US Treasuries.

Since early June, however, it has been declining steadily, as investors appear to be getting more and more convinced that the "end of the world" is not happening just yet.

In other words, people started selling dollars and picking up little pieces of risk - Australian dollars, gold, etc.

There was a bit of a hiatus to this very tentative getting-back-into-the-water in early August on a renewed ripple of nervousness driven by a combination of troubles in Europe, poor US statistics and, of course, the increasing shrillness of the "end-of-the-world" gurus, who were incensed that markets were not following their explicit instructions.

Of course, markets were thin during this period, since it was summer vacation in the more developed markets. But come September and the party people - the real risk-takers - were back, and boom!

Indian equities were one of the first out of the gate, followed in short order by more gold, a wide array of commodities and, finally - by the end of September - the rupee and other animals.

To be sure, several other currencies had begun rising earlier - notably, the Brazilian real, the Aussie, other Asian currencies, the euro and the yen. By the second week of October, the DXY had fallen to nearly 75, almost 15 per cent down from its May peak.

The sharp move had markets squawking. The Bank of Japan intervened to prevent further strengthening for the first time since 2004.

The Swiss National Bank has been plugging away; the Brazilian government has been complaining about competitive devaluations; the eurozone and the US are focused on Chinese recalcitrance.

Even our RBI got modestly into the fray, with a bit of intervention at 45, and recent jawboning by senior RBI and government officials.

Metaphorically speaking, financial news has hit the front page. Everybody (apparently) is alarmed.

Following the aphorism, this means that it's all gone too far and is ready for a hiatus, and probably at least a little bit of an unwind.

Let's focus the story on India. First of all, FIIs and other investors are once again scrambling to get a piece of the action - a few weeks ago, I saw Indigo again full of green, young, white banker-types. As a result, the Sensex has rocketed and is flirting with its all-time highs.

Everybody has the same story: the long-term fundamentals are strong, but there could be some profit-taking - perhaps just before or after Diwali, and certainly by the end of the year. Valuations are stretched, but nobody wants to be the first to sell.

Now, an equity correction does not necessarily translate into a decline in the rupee, since investors may well divest but hold their funds in India. Another play, though - the upcoming basket of IPOs - could work differently.

Banks have already positioned themselves for the expected inflows - once the money does come in, they will happily cash their spread by selling rupees they bought at 45+ to investors at 44+. When the allotment is over, the oversubscription will have to be remitted out, which will create fresh demand for dollars.

The DXY, which is very highly correlated with both the rupee and the Sensex, could also see a correction. I don't believe the world is about to end, which means that the hysterical indicators (gold at an all-time high, the Aussie, for God's sake, almost at parity with the US dollar, and five-year US Treasuries yielding just a bit over 1 per cent) are over the top - clearly, looking for any reason to take a breath.

Since January, my forecast for the year had been a range of 44.50 to 48.50. One end of that range has been met (and, in fact, breached slightly). While I don't believe we will see the other end of the range this year, I think the odds on some correction are high. Option prices are down, offering a good opportunity to protect against any sudden decline in the rupee.

 

Jamal Mecklai
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