‘Operation Twist' and what it means to Indian markets

The US Federal Reserve launched its new initiative “Operation Twist” with the main aim of reducing long term interest rates, promoting lending and stimulating the economy.

Operation Twist

Under Operation Twist, Federal Reserve will replace $400 billion of short-term debt in its portfolio with longer-term treasuries in an effort to reduce borrowing costs and counter rising risks of a recession. The central bank will buy securities with maturities of 6-30 years through June, while selling an equal amount of debt maturing in three years or less.

The programme will extend the average maturity of the Fed's Treasury holdings to 100 months by the end of 2012, from 75 months. The Fed's System Open Market Account held $2.64 trillion in securities as of September 14.

The main aim of this move seems to be to take the long-term interest rates down and flatten the government bonds yield curve. Due to virtually zero short-term rates, a large number of banks have been just playing the yield curve and not lending in the markets.

As the yield curve becomes flatter for longer time frames, the Fed seems to be betting that banks will be forced to lend. The availability of money in terms of narrow money supply does not seem to be an issue in the US economy, however, the broader money supply is not growing and consumer credit continues to shrink.

Previously, the Fed had been reducing its holdings of mortgage securities to reinvest that money in treasuries instead. The bet now seems to be that this will promote refinancing and leave greater money in the hands of households which can be used for consumption.

Since 70 per cent of the US economy is consumption dependant this move seems to be targeted towards reviving the housing market and also consumer sentiment.

No QE3

The avoidance of QE3 is the best thing to have happened. The additional money that was being printed was only fuelling speculation in commodities and currencies. This had led to inflation spiking up and impacting consumer sentiment.

The lack of QE3 combined with the issues in the Euro zone are likely to be positive for the US dollar. The US dollar index is looking extremely bullish technically and is pointing towards an eventual move towards 82-83 levels from the current levels of 78.

The sentiment in the near-term were also impacted due to the downgrade of three US Banks by Moody's. Moody's Investors Services announced the downgrade of Citigroup, Wells Fargo, and Bank of America — three of the United States' top banks.

Whither markets

The initial reaction of the Indian stock markets have been negative. However, the reaction cannot be just attributed to the US Fed action as it is also a combination of the developments in the Euro zone and data releases from China which indicated slowing growth.

On an overall basis, market valuations look cheap at this point of time. Slowing global growth combined with a lack of incremental money printing should lead to a significant commodity correction over the next six months. This will bring inflation down and will be incrementally positive for the Indian markets which have largely underperformed due to inflation concerns.

On the flip side, an up move in the US dollar, combined with a USD shortage in the global economy has lead to a sharp downward move in most EM currencies except China.

Implications

This will have two implications: It will somewhat reduce the impact of the falling commodity prices on inflation as the fall in prices is countered by weaker currency. However, it will also make exports of countries like India much more competitive to China and help in addressing global imbalances of trade.

There are several indicators of panic in the markets on Thursday which include:

Pull-outs from equity funds.

Record buying in gold which has taken gold prices to a premium to platinum. According to newspaper reports there is a shortage of storing space for gold due to the amount of investment buying that is happening.

The yields of US government bonds and German Bunds have gone to all time lows thus indicating a desire for safety over returns.

Traditional long-only funds have been losing money and leveraged hedge funds have seen record flows with the industry growing rapidly this year.

The sentiment is likely to play out over the next few weeks. However, fundamentally the case for decoupling of emerging markets from the developed world has become much stronger.

Growth prospects

As fear subsides, we will see a significant outperformance of high growth, non-commodity focused emerging markets. India is likely to be at the forefront of such a move unless and until the impact of government inaction on crucial economic decisions continues for a prolonged time period.

As the market correction continues along with the time-based correction, the downside for the markets is reducing and the upside potential is increasing. The level of 4,700 for the Nifty and 15,700 for the Sensex should hold for the markets.

Valuations at 12 times 2013 earnings and a peaking interest rate cycle also provide downside protection. Financial market linkages could create some downside in the near term but it will be a time to buy.

(The author is CEO — PMS, Prabhudas Lilladher Group. Views expressed are personal)