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.

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.

I ask Rupee: Are you ‘Tumblr’ or ‘Tumbling’?

The headline seems funny, right? But it is a grave concern for the Indian economy.
Tumblr was worth so, Yahoo! bought it. But do you think rupee is worth in the current market situation? The Indian rupee is no more blockbuster currency among Asian currencies as it has fallen miserably this year.


If we see the quantum of fall this month itself, it fell more than 10 percent. To  evaluate how rupee has performed, read the article from moneycontrol.com; Rupee to see worst quarter in 10 years.

Now if we come to the basics, rupee’s downward spiral can be attributed majorly to the current account deficit, sudden policy change by major central banks, read: U.S. Fed and Bank of Japan (BoJ) and the Indian economic bottlenecks. To understand more about economic bottlenecks please check one well written article by Mr. Swaminathan Aiyar; Why RBI’s fears about India’s growing current account deficit are misplaced.

In the present market scenario everybody expects more exports from the country and more internal consumption driven system. To do so banking entirely on Reserve Bank of India to cut the interest rate so that we can boost the competition and make money easily available in the economy is not justified. When your currency has depreciated to a level where foreign investors are dumping bonds and getting rid of the Indian stock market, plus overall investment to the country is low, an interest rate cut is definitely not a wise step. Thus, RBI is not in position to cut the interest rate even though the headline inflation has eased a bit.

Situation has become tricky for the Indian economy which has lost many opportunities in past few years. Its failure to implement GST, lack of clear cut investment policy, tax regime for corporates and FIIs/FDIs are few major points to be noted here.  Now, the Indian economic system has to wait and get played by other influential central banks else accept the new level of its currency value against the dollar for the coming months- expecting it will get subsidise soon.

When India had chance to grab investment flow it failed to capitalize. So far, asian counterparts have done good enough to keep their currency level under control and they are still favoured as investment avenues when compared to India. I wish, the Indian currency could have shined just like Tumblr. Alas! rupee is tumbling indeed.

Why so serious? The QE3 therapy is over huh?

Finally, the Federal Reserve had an acceptance tone – yes, it is enough as we have manipulated (read: damage) the bond market significantly, now let the economy decide the price. Thus, the situation is such that in the last two days the price discovery dynamics came into the picture as investors dumped treasuries in heavy number and amount.ImageThe yield for 10-yr bonds surpassed 2.55 percent, first time in 22 months.
According to ICAP, the last trading day of the week (ended June 21) witnessed a surge of almost 14 percent in trade (compared with 20-days average) to around $490 billion. Traders started offloading longer-dated treasuries (most vulnerable to these sort of circumstances), but the surprising factor was they also sold 7-yr and 5-yr notes in huge amount, betting the Fed will soon raise short-term interest rate. The market sentiment could be even judged by  changes in Eurodollar futures. The three month borrowing rates for December 2014 contract increased on the expectation that short-term rate will rise in the coming quarters.
According to Bloomberg report, the 5- yr TIPS have changed dramatically, so have the Eurodollar futures. Based on technical charts, many analysts expect the 10-yr bond yield to touch 2.75 percent in the coming days. The sell-off in the bond market has spiked mortgage rate. According to Paul Krugman, the nobel prize-winning economist, the Fed has played dangerously with the interest rates in the last five years,  and he suggests the Fed should accept inflation target of 3-4 percent. It is very pertinent to mention that Krugman wrote and affirms the importance of the determination of natural rate of interest in the current context of the U.S. economy.

Since the U.S. Fed has already played its cards, now time will tell us how the interest rate regime will turnaround. It would be interesting to see how the wider market spectrum of equity, debt and derivatives are going to behave.

‘Pair Trading’ using correlation

When a trader takes different position on two stocks in the market it is known as ‘pairs trade’. In pair trading the trader goes long in one stock and short in another stock. It is very pertinent to mention the selection of stocks are not that easy and it requires many statistics technique to build up the pair trade position on the selected stocks.
If executed properly, even when both stocks are up, the stock in which you were long will go up much faster than the stock in which you were short. And, when both stocks are down, the stock you were short will decline faster than the stock you were long.
Since selection of stocks in pairs trade is complex, correlation plays very important role here. Once correlation is established between the two stocks then trading is a cake walk.


Lets say, the trader zeroed down on Google and Yahoo, so if both the stocks move up and down at the same time then the correlation will be positive (+1). If Google move up and Yahoo move down at the same time then the correlation will be negative (-1). If both stocks move randomly then there will be no correlation (0).
How to get correlation? You will get correlation by dividing covariance of the percentage change in stock price by product of standard deviations of the two stock. Ideally, traders chose those stocks pair were correlation is 0.80 or above as it gives a very consistent relationship. When this correlation breaks or weakens i.e. Google moves up on the other hand Yahoo moves down, the trader bets on the price spread of these two stocks. When you decide to use correlation make sure that data taken is for more than six month or so. We can use beta as one more tool to do pair trading.  Happy trading!

Equity long short strategy in hedge funds

Hedge funds follow unique strategies of trading in the market. Equity long short strategy is one of them. As the name suggests the strategy takes long positions in those stocks which are expected to rise and short positions in those stocks which are expected to fall in the market. So, the hedge fund or the hedge fund manager applies this strategy to buy undervalue stocks and sell overvalue stocks in the market.

ImageAn equity L/S strategy can be applied to a sector, country and region specific area. In general, the hedge fund manager makes profits by keeping the healthy margin of spreads between long and short positions. Lets say, a hedge fund manager buys $1 million of Apple shares and sells $1 million of Nokia shares at Nasdaq, thinking, the upcoming event at Apple’s WWDC meet will lift Apple’s shares in the market and might impact the shares of Nokia (so going short on it). Imagine, if the manager has made perfect call on both the stocks – going long on Apple will fetch profits and going short on Nokia will give profits as well. But if the manager misses the call then what? So, consider another situation where both the stocks rise due to some event/news . In this case, the manager has to make sure how he/she has allocated  money for these stocks. It depends if the manager was using “130/30” strategy i.e. 130 percent exposure to long position to long and 30 percent exposure towards the short position i.e. long bias, this formula is purely up-to the manager to decide some even take 120/20 equity L/S.  In the above mentioned case since both the stocks were from the same sector, this kind of trading is also known as “pairs trading“. Overall, this strategy works when the manager predicts a perfect call.

RBI’s never ending dilemma

ImageIt seems the Reserve Bank of India (RBI) is having very hard times these days. No wonder if they complain the current bond yield and rupee fall is all because of the U.S. Fed and Bank of Japan (BoJ). Meanwhile, RBI has got entangled in the current account deficit and inflation problem, adding more headache to it is – the fall of Indian currency against the U.S. dollar. The fall in Indian Rupee has forced FIIs to dump the G-sec (Indian Bonds), and they had dumped bonds at record level during last few trading sessions. For the FIIs there is no point to hold their investment in the Indian bond market as the U.S. 10-year bonds are looking much more attractive. Plus the weakening of Indian rupee will hurt further investments (read article from Economic Times). The yield differential of U.S. 10-yr bond with Indian debt is at one year low.  According to the bond spread calculator of Bloomberg, the spread between US 10-yr bond and Indian 10-yr bond is around 504 basis point or 5 percent, it was at 7 percent, last year . It is very pertinent to mention that not only G-sec even yield for corporate bonds have also fallen in the market. Many fear the banks (PSU and private) might play the spoil sports and sell bonds in the market to book profits.

The Indian currency  is down almost 10 percent since first week of May, now hovering around 59 against the dollar. Today, traders reported RBI sold dollars in the market to curb the fall of rupee but previously done acts by RBI suggests it has failed to curb the fall of rupee due to structural economic problem. Meanwhile, chief economic advisor, Raghuram Rajan believes the rupee’s fall is a temporary phenomenon. Many economists think more liquidity in the market will ease the pressure from rupee.  In the coming weeks macro economic data will decide if the RBI is willing to cut the rates in July. RBI might give its  stance regarding the comfort zone with rupee in the currency economic circumstances on its June 17 monthly meeting.