Italian Mafia might rob global financial market

In the late 19th and early 20th century America saw emergence of Mafia in cities likes New York and other metropolitan due to Italian immigrations. (Italian mafia is also known as Sicilian mafia).Last week something similar happened in the global market, the Italian government released data for GDP, which declined by 0.2 percent in April-June quarter, sending negative sentiment across the financial world. Italy slipped into recession fomafia-guysr the third time since 2008.
Italian mafia is termed as “Cosa Nostra” (“our thing”). Thanks to globalisation, this poor GDP data from Italy can’t be termed Cosa Nostra for Italians as their problem is gong to be our problem.
Not only Italy but trade sanctions against Russia, poor factory orders from Germany, fresh statement from incoming European President Jean-Claude Juncker against Grecce debt write-off, French President Francois Hollande’s appeal to ECB on deflationary risk, Portugal’s $6.6 bln rescue plan for its troubled bank Banco Espirito Santo and ECB’s concern on euro zone recovery due to heightened Ukraine crisis, and no change in interest rate played major role in the financial market.
All the above mentioned events pushed U.S. treasuries price up (so, the yields fell). The safe haven investment demand was visible in Germany too, as investors clamoured for safe haven, sending German’s 10yr bunds yield to hit all-times lows.
On Friday, U.S. 10-year notes were down 1/32, yielding 2.43 pct, earlier in the day it fell to 2.35 pct meanwhile, 30-year bonds were unchanged to yield 3.24 pct, it also dipped a low of 3.18 pct during the trading hours.
There were some encouraging signs from U.S. economy, which helped the stock market. Weekly jobless claim fell, Purchasing Manager Index (PMI) for services were good, factory orders rose and Labor Department reported quite a pleasing data on labor productivity in second quarter which boosted investors confidence.
For the week, the Dow rose 0.4 pct, the S&P 500 gained 0.3 pct and the Nasdaq was up 0.4 pct.
The U.S. dollar was up for most of the week but lost all its gain and fell to one week low against all major currencies as escalated geopolitical tension laid down perfect opportunity for profit booking. The dollar was down 0.17 pct at 81.389 as of 4:30 pm EST, Friday.
Lets focus back on Italy. Why Italy is so important? Well Italy is world’s eighth largest and Europe’s third largest economy. Its GDP is about $2.6 trillion. The debt-to-GDP ratio is well above 120 percent. Thus, Italy has got enough butterflies in its belly to disrupt global financial recovery. Europe would be the obvious and worst hit if Italy falls into deep recession. And I won’t be surprise to see Sicilian Mafia migrating toward emerging markets; just to derail their growth story.

Disclaimer: I am not promoting Mafia neither influenced by Godfather (movie).

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It’s Raghuram Raj !

ImageThis Wednesday at RBI’s mid-quarter review of monetary policy an interest rate hike looks inevitable. One should blame the retail inflation (CPI) which burgeoned to 11.24% in November from 10.17 percent the previous month and not to forget Mr. Raghuram Rajan; an inflation hawk doesn’t believe in ‘Facebook  likes’. In its previous two meeting the RBI Governor has made it very clear – he won’t tolerate inflationary pressure on the economy.

Coincidentally, many socio-political analysts suggest unlike previous occasions there won’t be any pressure seen from the central government to cut the interest rate this time since Congress has blamed rise in price as one of the main reason for its poor performance in recently held four state assembly election, especially in Delhi.

To make the job little tricky for the RBI governor the factory output (IIP) contracted by 1.8% in October , down from 2% in September. But almost all polls and surveys had predicted hike in interest rate; possibly one last time in the current cycle. On the global front, the Federal Open Market Committee’s (FOMC) two day meeting will possibly paint new picture on the most expected-predicted-anticipated ‘tapering’ move. Many economists believe March 2014 would be that decisive month for the U.S. Fed to dial back its quantitative easing (QE) policy backed by good economic data. The U.S. Senate is expected to vote for new budget deal which will run till 2016 giving more room for the Fed to dial back its QE.

From RBI’s point of view a possible tapering will impact Indian currency. So far, to check the currency depreciation RBI has curbed speculation on dollar (by hiking interest rate). This month at New York, Raghuram Rajan apprised inflation as a key concern.  Market pundits are assured of WPI increase as well which is due to release Today. A higher WPI will concrete interest rate hike decision. Although, ever since Rajan became RBI’s governor, the Central Bank of India has shifted from WPI to CPI as its main guide for monetary policy. So, many market analysts expect hike in interest rate this time.
Its Raghuram Raj for sure!

Fee-based income holds the key for Banking system

ImageIn the era of quantitative easing and significant market competition, maintaining profitability through interest-based income is becoming very tough for banks. In the last two decades, interest margins have come under tremendous pressure. In modern times, banks prefer non-interest income i.e. fee based income to drive profitability and return on capital.

The 2008 financial crisis was a big blow for banks, especially for those depending broadly on interest-based income. As the global economic recovery still looks fragile, banks are finding it hard to do loan- and mortgage-based business i.e. interest-based business. The ultra-low central bank interest rate regime was supposed to spur economic activity, as it (theoretically) supports more lending activity, but many banks are hesitant in lending due to potential bad loan losses and slow demand for loans. It would be worth to mention the ultra-low interest rate regime has also dampened savings account activities in banks.

Most of the fee-based incomes (advisory and management fees) are fairly risk-free, as these services don’t involve significant capital investment.

In recent times, banks have reported handsome revenues from fee-based income; thanks to the spur in M&A activities and private equity deals (mainly in US). Since we are living in a globalized society, there are no boundaries for banks and they can reach out to any corner of the world, thus making many potential M&A and private equity activities lucrative.

It would be pertinent to mention that fee-based driven income cushions banks against market competition. In coming days, implementation of new banking rules and regulations are going to take a paradigm shift (Dodd Frank rule, Basel III). This might curb the freedom of leverage banks take on their reserves and provisions, which in turn will leave banks with limited capital or liquidity to do the traditional business of loans and advances –further constraining interest-based income.

Fee-based income is more volatile than interest-based income, but a range of services like wealth management, transaction banking, treasury, and investment banking are covered under fee-based income. The wide spectrum of fee-based service provides room for banks to shuffle service strategies.

In the prevailing economic situation, banks would look for more fee-based income, but they won’t be able to ignore interest-based income completely. They have to build up modus operandi for various possible economic situations. For example, they will have to understand, what would be good for business if the Fed will increase the short-term interest rate or possible ‘tapering’ in coming months? How to benefit from the global corporate houses’ quest for M&A?

Cut in MSF, FCNR swap: A win-win situation

Yesterday, RBI cuts MSF rate by 50 basis points (0.50%) which was inevitable indeed. It tightened the short term rates couple of months back and tried hard to curb the liquidity in the market so that the banks should not speculate against the US Dollar. Now the MSF rate stands at 9 percent.

One of the major factor which helped RBI to cut down the MSF rate is the “no tapering” decision by US Fed which in turn helped not only Indian Rupee but other EM currencies as well. “No tapering” or continuing in QE policy is bad for dollar as it will weaken dollar against other currencies.

Cut in MSF rate is most welcomed part but the most exciting part is the new FCNR swap offered by RBI to the Indian Banks.

The FCNR account (abbreviated as Foreign Currency Non-Repatribale accounts are offered by Indian banks to the NRIs) is a term deposit account meant only for NRIs. The Indian banks accepts only those currency deposits which are freely convertible i.e.US Dollar, British Pound (Sterling), Japanese Yen, Australian Dollar, Canadian Dollar, Swiss Frank.

The FCNR account can be open for minimum 1 year and maximum of 5 years term. An NRI can use the deposit balance to make local payment and yes the interest rate fetched will be tax free in India.

As the Indian banks raise funds through FCNR channel, they take the deposits in other currencies and exchange that with Indian Rupee in the market with prevailing forex rates for domestic lending.Once the term of deposit is over they return the fund with promised interest rate. Since the deposit term ranges from 1 year to 5 years, they hedge FCNR deposits by entering into the derivative market (Forwards contacts, NDFs etc).

Now, how does RBI’s FCNR swap going to work? Currently, in the forward market banks are paying per annum 7 percent premium for the US dollars.But RBI promises 3.5 percent premium per annum for 3 years FCNR deposits. Thus overall cost of hedging is going to be reduced for Indian Banks. On the side note, this facility is only for US Dollar deposits.

The Missing Sense: Indian Economy

“Expect the unexpected”. I must say today’s monetary policy decision by RBI (worth to mention the US Fed as well few days back)has made it clear to the market.

When everyone at financial street were expecting for a repo cut and more ease in the liquidity the RBI Governor kept the ‘inflation mandate’ intact.

The main reasons for RBI to increase rate (further tightening of liquidity) was primarily based on the CPI data and possible ‘Fed tapering’ in coming months which might drag the economy further.

Meanwhile, RBI Governor made it clear, he can’t ignore the inflationary pressure on the behest of so called liquidity ease; which banks are demanding from past few months.

In its mid-quarter policy, the RBI gave respite to short term borrowing by decreasing the Marginal Standing Facility (MSF) rate to 9.5 percent from 10.25 percent. Although it increased the repo rate by 25 basis points (0.25%) to 7.5 percent.

On the side note, most of the banks channelise short term funds through MSF, when the common way of borrowing dries up in the market. So, reduction in the MSF would bring down Certificate of Deposit (CD) rate in the market i.e. short term borrowing rates will gradually come down to sub 9.5 percent level. MSF rate was increased in July to curb the rupee depreciation.

With all the concerns on liquidity and growth I would like to bring some missing links which many of market pundits are ignoring. So, here are few missing sense which we need to check:

1. Our first quarter GDP ticked at 4.4 percent versus 5.4 percent year on year; lowest in four years.

2. One of the main components of Service Sector – Trade, hotel, transport and communication which comprises of small shops, restaurants and rickshaw-wala grew just at 3.9 percent (having 25 percent of weightage in the service sector). The slow pace of growth in the ‘trade, hotel, transport and communication‘ means there is slow employment growth for low income and low skill people.

3. Mining contacted by 2.8 percent in first quarter so were the manufacturing sector and capital formation by 1.2 percent, indicating the investment and consumption cycle are weak.

4. The Gross Fixed Capital Formation (GFCF) which accounts property, plant and equipment and excludes land purchase and depreciation was at 32.6 percent of GDP. The GFCF is a gauge used to check how good the economy is in utilising its capital. Previously estimated figures suggest the GDP should be around the level of 6.5 to 7 percent if the GFCF is 30 percent of the GDP but in the present scenario its is way behind that observed level. 

The bottom-line remains the same for our economy – we are failing to utilise our capital. If we can channelise our investment capital the economy will definitely shape up in a proper direction letting the RBI concentrate on the inflation check .  

D-Day: RBI strikes back

ImageToday, the Reserve Bank of India (RBI) will auction short term Cash Management Bills (CMBs) in the market. This step by RBI is seen as a dire desire to contain the liquidity and Indian Rupee in the market.

Under this scheme, every Monday the RBI will auction an amount of Rs. 22,000 crore of CMBs, wherein,  it will be selling Rs11,000 crore each in two CMBs maturing for 35 and 34 days on Monday and Tuesday, respectively. Although, the CMBs will carry characteristics of Treasury bills but the major difference lies in flexible maturity date. Unlike Treasury bills which carry fixed maturity date like 30 days, 91 days, 182 days, the CMBs will have flexible maturity dates between seven days and one year based on RBI’s view on prevailing market situation. RBI did sell CMBs On 25th July, 2013 which was for 28 and 56 days.

Will it strike and contain Indian Rupee?

Since the measure is for short term liquidity the CMBs will attract many institutional investors and fund houses as the bill maturing before 60 days will not be evaluated based on the prevailing market price thus fund houses will be free from any kind of accrued profits/losses in case of rise or fall in these CMBs.

Second point, this measure will keep the Indian Banks form speculating the Indian Rupee in the currency market as sell of CMBs will keep the short term liquidity at an elevated level thus there will be no leeway for banks to speculate Indian Rupee.

As the fall of Indian Rupee can be attributed to many economic factors but there is no doubt the speculative market is prudent enough to create further damage to the Indian Rupee in the currency market. Hopefully, this move will try to contain Indian currency in coming months.

Inverted Yield Curve: The Curious Case of Benjamin Button

The concept of ‘Inverted Yield Curve’ can be easily related to the ‘The Curious Case of Benjamin Button‘-  Hollywood’s fantasy drama movie.
In an ideal economic condition, a normal yield curve depicts low yield for short term papers (bills) with respect to the longer dated bonds (10-yr Treasury notes, 30-yr bonds).
But when the yields of short terms bills are higher than long dated bonds then it gives you an inverted yield curve. For those who are not aware of the movie, it was about a man who ages in reverse i.e. older to younger.  So, an inverted yield curve is a very unusual case similar to Mr. Benjamin Button.
Image  Image

Going by the terms, concepts and theory of economics; generally, an investor expects low return from short term investment whereas high return from long term investment. But when the investor believes that short term investments are risky and long term investment are secure even though they offer less return- this gives the yield curve a whole new look – an inverted yield curve.

The mechanism behind inverted yield curve
Imagine, the investors expect rates cut by Fed in coming months as the economic conditions are not favourable ( a perfect case would be recession period ). Since the short term bills closely follow Fed rates, investors will dump those bills on the anticipation that these bills will follow the Fed rates soon. In return they will flock themselves with longer dated treasuries, creating demand for it, which will shoot up the prices and bring down yield for those treasuries in the market. As everyone is running behind longer dated bonds, there will be few buyer for short term bills who will eventually demand for high coupon rates or yield, resulting, change in the dynamics of treasury yield curve see the graph below.

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Although it is very pertinent to notice that an inverse yield curve can be used to forecast the recession. Many economists and market pundits will agree that a change in a yield curve always sends signal that the economy might see some hiccups in coming times. In the U.S., the treasuries yield curve got inverted before the recession of  2008, 2000, 1991 and 1981. The inverted yield curve had got many curious moments in past. In July 2006 the debt market witnessed inverted yield curve which remained  inverted for almost a year – till June 2007.
In the behest of cooling off the housing bubble the Fed increased its rate to 5.75 percent in 2006. After realizing the situation, in September 2007 it started cutting down rates consecutively ten times to near zero percent in 2008; the year which embarked official recession in the U.S. economy. One irony is ‘The Curious case of Benjamin Button’ got released in the same year – 2008.