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  1. In 2016, divergent monetary policies, political realignment can drive more volatility in FICC, asset markets

In 2016, divergent monetary policies, political realignment can drive more volatility in FICC, asset markets

Over 2015, we have seen both the divergent monetary policy as well as the political realignment around the globe become intense. Hence, over the next twelve months, we can expect far more volatility than what we saw over the past year.

By: | Updated: January 2, 2016 8:23 PM
Indian economy, economic growth rate

Over 2015, we have seen both the divergent monetary policy as well as the political realignment around the globe become intense. Hence, over the next twelve months, we can expect far more volatility than what we saw over the past year. (Express Photo)

Wish you all a very prosperous New Year – 2016! It is that time of the year, when we are tempted or bullied to pen down the forecast for the next 12 months. It is also that time of the year when the mind, quite illogically though, wants to eye a fresh perspective. As a result, quite unnecessarily an assumption is made as if economic cycles and financial markets also actually follow a calendar, which starts anew every January. Sorry to disappoint, but it does not. At any point in time multiple themes drive movements in assets prices. In this article we shall try have a look at the some of those factors which can play a role in defining trends in financial markets. In these potpourri of themes driving assets prices, we would suggest focus on two:- 1) Divergent monetary policies between US and other major world central banks and 2) Extreme political realignment all over the world. In this article we shall explain in detail how factor number one played its part. As far as the latter one goes, we shall not spend too much time on that in this piece, but may be we will explore it in later articles.

Between 2008 and 2012, we were in a period of unprecedented policy convergence. US was underwriting the easy money policy by its serial injections of cheap liquidity through QEs and twists. The weak dollar kept world economy and asset markets well-greased. Emerging nations, which accounted for lion’s share of the growth in world GDP since 2000, benefitted a lot from easy monetary policy from US Fed and consequent surge in commodity prices. Governments, banks and businesses in these countries dollarized their balance sheets. However, come 2013, US Fed made overtures about ceasing to bankroll the world with cheap dollars. They finally launched the ‘taper’ program and which finally culminated into the higher interest rates in America. It was around that time, US dollar completed its bottoming out and surged upwards. The bull run in US dollar triggered the collapse in commodity prices and made funding expensive for EMs. A PnL squeeze and balance sheet propagated through the emerging markets. The effect was visible, EMs which were the driving engines of world economic growth stuttered. The emerging market were already feeling the brunt of weaker growth developed market, their traditional centers of consumption. The debt crises had adversely affected the growth in these demand centers. Now with the new dollar squeeze ravaging through their economies and financial system, EMs faced major whammy of dollar-debt funded burgeoning excess capacity and weakening demand. Deflation is a resultant impact.

The effect of the divergent monetary policy did not end with the EM dollar-commodity squeeze, it triggered a second round impact, the strangling of the Red Dragon. China through its soft Peg of the Yuan to US dollar had effectively imported the monetary policy from America. The result was a massive stimulus and credit binge of 2008-2012, that caused debt to explode in the Asian giant. According private estimates, the overall debt in China could be anywhere between 250-300% of GDP (USD 25-30 trillion). The kind of debt explosion China saw post 2007 was unprecedented and is very crises prone. It has to be mentioned that the growth in debt is still continuing. Rising idle capacity and debt caused deflation in China. A country facing low inflation or deflation needs a much easier monetary policy than what China is having currently. However, if they jettison the US monetary policy now, which is becoming tight, they risk a sharp devaluation in the Yuan against the US dollar. Chinese thought they can postpone the inevitable by engineering an equity price boom. However, that party did not last long. As that bubble came crashing down, Chinese finally relented and allowed the Yuan to devalue. This caused further collapse in commodities and a further rise in US dollar. EMs got a second round knock from this shift.

Over 2015, we have seen both the divergent monetary policy as well as the political realignment around the globe become intense. Hence, over the next twelve months, we can expect far more volatility than what we saw over the past year. China-EMs-Dollar nexus shall mean that central banks v/s market skirmishes can lead to heightened volatility in asset prices and currencies. One after another episode of asset price swoon can bring the central bank and regulators out of their camps to douse the fire and restore confidence, which can lead to opportunity for traders who can embrace volatility in their wealth creation plan. Currency market, by design is an instrument which can benefit from both phases of volatility, low as well high. Long convexity and long carry are two ways which work in those directions. Interest rates are also going to be fascinating asset class where volatility shifts can create opportunities. Commodities have been very obedient in their collapsing trend; we expect that to change, as more spiky phases are observed. So all in all, the FICC universe (fixed income, currency and commodities) can become an active area in world financial system. However, one should never forget that high volatile phases demand discipline in trading and whoever ignores that may face significant net worth drain.

We are witnessing one of the longest recoveries in US economy and at the same time it is the weakest recoveries it has been since WWII. The two contrasting situations are a result, of debt crises in a world awash with too much of it. Unless and until that baggage is brought down to a comfortable level, we shall see more of weak and crises prone economic recovery.

Before we conclude we would touch upon the outlook for the Indian rupee for the upcoming week. We can see rupee remain within a range of 65.80/66.00-66.50/60 on spot. With the Chinese Yuan dropping against the US dollar to the lowest level since summer of 2011, we would expect RBI not become too comfortable with a strong rupee. Rupee is already one of the strongest currencies on a spot return basis and for it to appreciate more would tantamount to an unnecessary squeeze around the neck of the export driven sectors of the Indian economy. The newly hiked limits in government bonds for FIIs is what is prompting a long bias in the rupee. However, we expect the sovereign to duly absorb those inflows, which could be between $2-3 billion, and allow USD/INR to form a base around the 66.00 levels. Eventually, this base formation can allow depreciation back towards 67.00/67.50 levels on spot over the next couple of months.

Source:  Lance Roberts of Real Investment Advice

Source: Lance Roberts of Real Investment Advice

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