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ISSUE

MONTHLY JOURNAL OF FINANCIAL MARKETS

07

InteliGen

DECEMBER 2012 In this issue QE-The Panacea for the US Financial Jargon’s Knowledge bank-Impact of QE on India Key Global Indicators Market Overview (Nov 2012)

P.1-P.2 P.2 P.3 P.4 P.4

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QE-The Panacea for the US Quantitative Easing (QE). Do not underestimate the power of these two words. For the third time since the global financial crisis in 2008, QE has become a popular buzz word for the US economy. Quantitative easing refers to an alternative form of monetary policy used by monetary authorities to increase the money supply, by buying government securities or other securities from the market. Thus enabling banks and financial institutions to offer loans at lower rates which will in turn help spur demand. In recent times, monetary authorities across the world including the European Central Bank, the Federal Reserve (Fed) and Bank of England would have employed quantitative easing as a way of revitalizing their economies. Ever since QE1 was unleashed by the Fed after collapse of Lehman Brothers, the far-reaching effects of this cheap money have been doubted. However, the US central bank has been super optimistic about its power to set things right with consecutive rounds of money printing. The Previous Rounds Prior to QE1, growth in the US followed a downward trajectory with a negative growth of 3.49% recorded in 2009. The first round of quantitative easing began in November 2008, where the Fed initiated purchases of up to $500 billion in MBS and in December 2008 cut interest rates to near zero, its lowest rate in the history of the Fed. In March 2009, the Fed expanded this stimulus package and purchased a further $750 billion in MBS. QE1 ended in March 2010 with a total of $1.25 trillion in MBS purchases and $175 billion in agency debt purchases.

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The main purpose of QE1 was to support economic activity by keeping longer term private interest rates lower than it otherwise would be. Indeed, interest rates fell across the board on longer term bonds, consistent with a contraction of supply effect. The financial markets started to perform better and the economy had somewhat recovered as evidenced by the increase in the growth rate in 2009. However, the unemployment rate was much too high as it increased to approximately 9.28% in that year. On November 3rd 2010, the Fed responded to the slowing of the recovery and announced plans to buy $600 billion in long term US Treasury bonds, in addition to the reinvestment of an additional $250 billion to $300 billion in Treasuries from earlier proceeds from MBS. This round of QE2 lasted for a period of eight months and ended in June 2011. The intention was once again to renergize the economy and push yields on Treasuries and bonds down. The economy responded in a similar manner as it did for QE1 and experienced a revival in demand, production and consumer confidence. The high unemployment rate, however, remained an issue to contend with. When recovery again appeared to be losing steam in mid-2011, the Fed on August 9 2011, announced that the Fed rate would remain at exceptionally low levels through mid-2013. This was the first time, in the Fed's history that it committed to keeping its policy rate at a certain level for a specific period of time. Though the Fed rate was kept at record low levels, the US economy continued to struggle with an unacceptable unemployment rate of 8.3% recorded in August 2012.

The Fed in Action Again The Federal Reserve, frustrated by persistently high U.S. unemployment and the torpid recovery, launched an aggressive program to spur the economy through open-ended commitments to buy mortgage-backed securities and a promise to keep interest rates low for years. On Sep. 13th 2012, the Fed, in its efforts to lower its persistently high level of unemployment and to spur the economy, announced the plan to purchase mortgage backed securities (MBS) of up to $40 billion per month (about $480 billion per year) and to maintain a zero-interest rate policy (ZIRP) until mid2015. Notably, this QE3 is open-ended, lacking any definition about the duration of the program. These transactions translate into an 18% year-over-year increase in the US monetary base. By buying securities from the open market, the Fed aims to suppress mortgage rates. With interest rates near zero, investors would be forced to buy riskier financial assets. This in turn would push prices of houses and equities higher. No wonder the US stock markets alone gained about US$ 400 bn following the announcement of QE3. The Fed hopes that this will revive sentiment and boost consumption and investments. And this will probably translate into higher growth and higher employment. The Other Way Round The Fed's intent is to keep interest rates low to induce higher real growth (and lower unemployment) in the economy. There is an inherent contradiction between the Fed's action and its objective. If the economy starts growing faster, market interest rates cannot and will not stay low, no matter what the Fed does. Thus, the only way the Fed can keep interest rates low for an extended period is if low interest rates do not translate into a stronger economy. The Fed's earlier moves in this recession (QE1 & QE2), interest rates have stayed low, with mortgage rates and corporate bond rates at historical lows, but they have done so, because the economy has stagnated. On the flipside, if this experiment worth billions of dollars fails, it is going to have massive long term repercussions. It would push inflation higher. Income inequality would rise sharply. The standard of living would decline. The repercussions of the failed experiments would have to be borne by future generations.


Financial Jargon’s LTRO (Long-term refinancing operations) LTRO is an acronym that stands for "longterm refinancing operations", which are used by the European Central Bank (ECB) to lend money at very low interest rates to euro zone banks. LTROs provide an injection of low interest rate funding to euro zone banks with sovereign debt as collateral on the loans. Seeding Ground for QE3 and Market Reaction During 2012, the already weak recovery from the recession weakened further. At the same time, inflation remained close to the Fed's new target rate of 2%. The Fed has a dual mandate from Congress to strive for both low inflation and low unemployment. It was meeting its low inflation mandate, but unemployment remained stuck above 8%, after having fallen from its peak of 10%, because its dual mandate was getting further out of balance the Federal Reserve announced a third round of quantitative easing. The goal is to pump more liquidity into the economy in a way that will reduce mortgage interest rates further.oil climbed 1.3 percent to $98.31 a barrel, a four-month high, and while gold jumped to the highest price since February as it is the only safe currency around and unlike paper currencies, cannot be printed at will. But now many critics fear that more “money printing” will trigger hyper-inflation and a collapse of the dollar. In each of the first two rounds of quantitative easing, the dollar weakened in value against a basket of foreign currencies. Thavt makes sense, because the Fed is artificially lowering the interest that investors can earn by parking their money in dollardenominated securities.

Quantitative Easing – Where lies the misplaced fears and hopes? During the Fed's aggressive easing of monetary policy during the financial crisis and during QE1 and QE2, the Fed added about $2 trillion of assets to its balance sheet and an equal amount to its liabilities, mainly the reserve deposits of banks. Normally, such an expansion of bank reserves would trigger additional bank lending and investing until bank deposits—the main part of the public's money supply — grew by a multiple of the increase in reserves. However, given the stresses on banks during and after the financial crisis, they have held onto most of those new reserves as “excess reserves,” thus truncating the moneycreation process. For the past two years, the M2 measure of the money supply has grown only around 6-7% annually. Thus, instead of creating lots of money as most critics assume, the Fed paid for its asset purchases by creating bank reserves, which the banks effectively “sterilized” by holding onto them. The bad news is that this sterilization meant that the stimulus to the economy was much less than intended. The good news is that money not created—usually called “printed” for effect — is not spent, and money not spent cannot cause inflation and a weakening of the dollar. Most measures of inflation are near the Fed's target of two percent and the trade-weighted value of the dollar is about where it was before the financial crisis. The real onus of job creation lies with the fiscal policy and what the other economies around the world are doing. And things are not looking good on both these fronts. The US is fast approaching a fiscal cliff where tax cuts will expire at the same time the Government will implement automatic spending cuts. Thus, this could well send the country sliding into recession if corrective measures are not taken. Besides, manufacturing, one of the key drivers of the US economy, would also slow down due to problems in Europe. In light of these factors, all that seems inevitable is that QE3 will end up inflating stock prices without any marked improvement in the overall economic scenario. It will lead to more inflation and more debt. While it can goose the economy in the short term, it will heighten the downside in the long term.

Austerity A state of reduced spending and increased frugality in the financial sector. Austerity measures generally refer to the measures taken by governments to reduce expenditures in an attempt to shrink their growing budget deficits.Austerity measures are generally unpopular because they tend to lower the quantity and quality of services and benefits provided by the government.

MBS (Mortgage-backed security) A mortgage-backed security (MBS) is an asset-backed security that represents a claim on the cash flows from mortgage loans through a process known as securitization. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets.


Knowledge Bank

Impact of QE on India Indian equities have rallied since September 2012 on the back of global quantitative easing and a new found vigour by the Indian Government for decision making. The open-ended approach to QE3 is likely to have a prolonged positive impact on equities and unlikely to create asset bubbles in commodity prices due to excess capacity and a slowing China. The near to medium term will see portfolio flows continuing into emerging markets with decisive Governments. Other factors like rate cuts, benign commodity prices, correction in current account deficit and a consequent appreciation in the Rupee are added triggers. Whether this is just another 'risk on' trade or the start to a new bull market is open for debate. Nevertheless, the current situation presents a tactical opportunity for equities, not to be missed. After the September rally, the benchmark indices offer a potential 7-10% appreciation from current levels.

Reforms and money supply: There's more to come Indian equities have rallied after global easing coincided with the Indian Government getting into action on the policy front. Compelled by the fear of a downgrade of the country rating to junk status, the UPA shrugged off the lethargy and announced a slew of measures from diesel price hike and capping of subsidies to opening up of foreign investment in many sectors. The Congress-led UPA has managed the numbers in Parliament over FDI issue and is likely to go ahead with more reforms. This is because downgrade fears may have subsided for now, but they have not been dispelled completely. The ruling Government is also looking for an image makeover. Even in the low probability event of an early election (anyways may just be a few months before the due date), the Government may be seen as martyr of sorts, rather than an under� achiever.

The timely action from global central banks helped equity markets immensely. On September 13, 2012, the US Federal Reserve announced another quantitative easing programme, the third of its kind. But this time it was different. The Fed's easing focuses on mortgage-backed securities and not Government bonds and is an open-ended programme, both in terms of time duration and amount involved. This money, which the banks by selling Mortgage Backed Securities (MBS) get at artificially low interest rates, finds its way into commodities and emerging market equities such as India where returns are much higher. The ECB and the Bank of Japan also convened similar monetary action. What's more, the Fed promised to keep interest rates low till 2015. This can be read as a sign of abundant liquidity flow, largely favouring equities. To call this a bull market would be premature with trouble still brewing in many parts of the world. Unless Governments take concrete measures, economies could easily head back into a recession. But one thing is clear; money flow will remain upbeat in countries with decisive Government action, till the 'risk on' trade lasts. Already, net FII flows into Indian stock market have been $18bn year-to-date and $5bn since QE3 in September till date.

Risk of commodity price bubble Both earlier rounds of QE1 and QE2 had a direct impact on the price of Oil. A higher price of Oil led to inflation in the country and as India imports about 70% of its Oil requirement, it affected the balance of payments. Coupled with a higher subsidy bill, it further affected the fiscal deficit as well and the currentaccount deficit in turn put downward pressure on the Rupee, which inflated the Oil import bill even further. The price of Gold has gained consistently ever since quantitative easing as a strategy was undertaken by central banks around the world. Gold is considered a hedge against inflation and also against fiat currencies, which are being devalued by loose monetary policies of the central banks. It went from just below $800/ounce to around $1600/ounce by the time QE2 ended. Gold imports in India account for a major part of the current account deficit, so a higher price definitely worsens the current account. Gold imports reached a low of around 450 million tonnes in 2008 and reached around 958 million tonnes in 2010. But unlike the previous rounds of quantitative easing, the risk of a speculative bubble in commodities is low due to excess global capacity and a slowing Chinese economy. Softening commodity prices augur well for emerging market economies like India and will boost margins of many corporates. However on the front of trade deficit on account of gold import, India needs to be very cautious.

QE3 triggers fear of new currency wars Fear has crept into the forex markets: fear of central banks. Currency traders are rapidly shifting assets to countries seen as less likely to try to weaken their currencies, amid concern that the fresh round of US monetary easing could trigger another clash in the "currency wars". Fund managers are rethinking their portfolios in the belief that QE3 will weaken the dollar and trigger sharp gains in emerging market currencies. Such moves would cause a headache for central banks worried about the domestic impact of a strengthening local currency, leading to possible intervention. Currencies whose central banks have either intervened or threatened to intervene since QE3 have been underperforming the US dollar as investors have steered clear. The Czech koruna is the worst-performing major currency against the dollar since QE3 was launched, according to a Bloomberg list of expanded major currencies. The governor of the Czech central bank last week raised the prospect of forex intervention as a tool to stimulate the economy. The Brazilian real is also weaker in the past two weeks after Guido Mantega, finance minister, made it clear that the government would defend the real from any fresh round of currency war sparked by the Fed's move. Currency intervention has been a growing concern for forex investors, with many scrutinizing the history of a central bank's interventions before deciding whether to invest. Investors are opting for currencies that have weakened substantially this year. Russia and India have currencies with strong rate support and levels

which remain well below their best levels of the last year, hence pose less intervention risk. Some currencies are strengthening on a combination of Fed easing and domestic factors. While the Indian central bank is not seen as likely to intervene to stem any appreciation in the rupee, the currency has also been popular this month due to a reform package from the Indian government aimed at stimulating the economy. However, some investors believe the QE3 effect could be lower this time. They argue that central banks in emerging markets face a tough decision over whether to weaken their currencies to help struggling exporters and stimulate growth, or allow them to strengthen tooffset the impact of rising food prices. In fact, the US dollar has shown signs of resilience since QE3 as fears over the health of the Eurozone continue.

What lies ahead for India? If history repeat itself and commodity prices increase, it will further fuel inflation and due to our weak policies increase the subsidy burden as well as the fiscal deficit. It is a fact, well established, that India is a net looser from the QE policy, which is popular with the central banks of the West. As of now, there isn't much of an inflation problem in the US, but there are worries that if such expansionary monetary policies continue, inflation could rear its ugly head which would then force the Fed to raise rates before its stated timeline of 2015. A rise in interest rates in the US would certainly be very bad for India, as investors will most likely withdraw money from India to cover up for losses at home which would not only affect the stock market but also the rupee.


Market Overview December 2012 Equity market roundup-November 2012 In month of November shows the upward trend after the consolidation in the month of October on the back of global liquidity and hopes of FDI implementation. on the start of the month HSBC PMI reports that India's manufacturing index stood at 52.9 in October inched up to September 52.8 which market accepted positively. In the last few session of month the Indian markets rallied sharply, amid expectations of a resolution of the logjam over FDI in retail, aggressive short covering and Goldman Sachs' upgrade on Indian equities and got support from positive global cues after comments from House Speaker John Boehner on a possible compromise to avoid the 'fiscal cliff' lifted market Sentiment. The BSE Sensex ended with gains of 4.5 per cent, closes at 19339.9 hit 19-month high of 19205.33, since April 2011 and NSE Nifty closes at 5879.9 with 4.6 percent gain, hits the 52 month high.

Forex market roundup-November 2012

Key Global Indicators New Home Sales Released monthly by ECB, it measures the change in the total quantity of domestic currency in circulation and deposited in banks. Actual > Forecast is good for currency; it is positively correlated with interest rates- early in the economic cycle an increasing supply of money leads to additional spending and investment, later expanding money supply leads to inflation in the economy, so it is an important indicator for the economy. As per data of 28 November 2012 actual is 3.9% to 2.8% of forecast. Next release is on 3 January 2013.

In the month of November global uncertainty and dollar demand to purchase oil led to depreciation of rupee against dollar. Moody's stable outlook towards Indian market and finance minister P. Chidambaram's comment on fiscal deficit to manage at 5.3% rescue rupee to fall more against the dollar. INR rise was also supported by fiscal cliff concerns and agreement by European finance ministers to ease the terms on emergency aid for Greece, which weighed on the dollar. Rupee depreciated 0.8% for the month to close at 54.53 vs USD.

Bullion market roundup-November 2012 Early in the month gold rallied on demand as a safe haven during a global economic meltdown, the U.S dollar appreciated against the Euro, yen, Aussie and Canadian dollar; the Euro/USD and AUD/USD currency pairs are usually strongly correlated with gold and silver prices. Conversely, during the second part of the month, the Euro/USD and AUD/USD rallied because of Concern that U.S. lawmakers may fail to reach a settlement in talks aimed at avoiding self-imposed tax increases and budget cuts known as the fiscal cliff. The depreciation of the USD may have positively affected gold and silver. In particular, the USD depreciation may have had a stronger effect on silver than on gold. In the month of November, gold declined by 0.48%; silver, rose by 2.75%.gold closes at 1712.7/troy ounce.

Overnight call rate Released by Bank of Japan (BOJ), 14 times in a year. It measures the interest rate at which the BOJ rediscounts bills and extends loans to financial institutions. Actual > Forecast is good for currency, short term interest rates are the paramount factor in currency valuation. As per the data of 19 November 2012 actual is <10% equals to forecasted figure. Next release is on 19 December 2012.

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Core CPI m/m Released monthly by government of Canada, it measures change in the price of goods and services purchased by consumers, excluding the 8 most volatile items. Actual > Forecast is good for currency; consumer prices account for a majority of overall inflation. Inflation is important to currency valuation because rising prices lead the central bank to raise interest rates out of respect for their inflation containment mandate. As per the data of 23 November 2012 actual is 0.2% to 0.3% of forecast. Next release is on 21 December 2012.

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InteliGen Issue 07 December 2012

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