The "sudden" sharp rise in the yen, drop in equities worldwide and rise in credit spreads had, in a sense, been anticipated by many observers since the end of last year.
However, few were willing (or able) to stick their necks out in terms of targeting a point in time at which the excessive risk that had been piling up over the past two or three years would begin to unwind.
Our last research report, entitled "Will Global Risk Aversion Rise in 2007?" published at the end of January, pointed out that ". . . the most striking evidence we have found of the cyclical nature of the recent decline in volatility is the strong correlation between the Fed funds rate and the volatility of the S&P 500."
The correlation between the average value of the Fed funds rate lagged by two years and S&P volatility has been rising since 1989 and was, by January 2007, close to 100 per cent. The analysis showed that since Fed funds had risen sharply over the past year, "some time over the next two years S&P volatility should rise sharply, reaching levels last seen in 1996-2000, the time of the Asian crisis, the Russian default and LTCM."
Sure enough, the process has started, and the fallout could well last for a while. This is particularly true given the huge volume of global assets that are funded by the carry trade (borrowing in yen and Swiss francs), convoluted liabilities like collataralised debt obligations (which impact a wide array of investors when they are unwound), and, of course, the extravagantly structured home loans in the US, particularly in the sub-prime section (which is already unwinding).
Our research showed that while the impact on US equities is not determinate, an "increase in financial market volatility has usually been associated with a sharp rise in the dollar--perhaps the safe haven effect."
This was seen very clearly in the period from 1996 to 2002, when rising financial market volatility was accompanied by a steadily stronger dollar, despite the growing cacophony about the US "twin deficits." Of course, currency markets are always subject to strong counter-cyclical forces. For instance, the current terror in the US housing market has almost everybody convinced that the Fed's next move will be to lower rates, which could weaken the dollar.
However, in my view, that will be a short-term force, which will be overwhelmed over time by the reversal of the aggressive risk-seeking behaviour of the past few years, which is still playing out. Thus, I believe we will -- over, say, a six- to twelve-month horizon -- see a stronger dollar, certainly against the non-JPY majors. In other words, euro and sterling receivables should celebrate the current still excellent levels to sell.
A sharply stronger dollar would usually be associated with a sharply weaker rupee, both because of the increased linkages between India and the world, and also because an increase in global market volatility could be driven by (or drive) a new round of emerging market risk aversion.
Perhaps more importantly, the RBI and the government have clearly stated that they will not tolerate a stronger rupee despite the impact on money supply of the RBI's ongoing intervention. The continuing decline in export growth (Jan exports grew by around 6% over the previous year, after December's already anaemic 7% growth) will doubtless strengthen their resolve. Thus, after a long time, we could see both these forces--the market and the regulators--acting in concert, which could push the rupee lower. Perhaps, much lower.
In the January report, our research team had recommended buying call options on the dollar (against the rupee); the good news is USD/INR volatility has not yet risen substantially--Allah be praised, even the RBI's policies can be beneficial sometimes. Thus, I feel that short dollar positions should protect themselves with options and exporters should, fingers tightly crossed, sit tight, looking for an inevitable swoon in the rupee sometime in the next two months.
The Indian stock market, of course, is in for a rough ride. In an earlier column, I called for a 10-15 per cent decline in the Sensex. It was at 14,539 at that time, and is already (at 12,866) down about 13%, but it feels like there's still more to come.
It is difficult to say when the decline will end and how long it will take, although markets have a way of moving very swiftly--whoosh!
In any event, even when the bottom is found (globally, I mean), there would doubtless have to be a period of wound-licking. Thus, any rally--in any of the "hot" risk assets, from Indian equities to commodities, like copper, to credit spreads on exotic instruments--should be seen as a selling opportunity.
Of course, this is India, and we are still very insulated from some of the more exotic investment processes that will be unwound. So, largely irrespective of the scale of global terror, our markets will not collapse. Indeed, we may well be the first market to recover. I would target 12,000 or a bit below as levels to get back in.
Enjoy the ride!
The author is CEO of Mecklai Financial.
