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Relief rally, no renewal of faith by bulls

When the central bank hiked policy rates only by a minimal 0.25%, there was a big relief rally. As a result, the Banknifty index gained a monstrous 13.5% last week.

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Serious chess players quickly learn the axiom that the “threat is usually worse than the execution”. So it proved when the credit policy came through. The market had sold down bank stocks in the expectation of a hawkish Reserve Bank of India (RBI) policy. When the central bank hiked policy rates only by a minimal 0.25%, there was a big relief rally. As a result, the Banknifty index gained a monstrous 13.5% last week.

In fact, there was relief all around as all the major indices rallied by well over 5% in settlement week. The institutions returned to the party, with FIIs and mutual funds buying close to Rs 1,000 crore each. The derivatives settlement went off quite smoothly with volatility staying on the lower side of expectations.

Technically, however, the selloff on Friday, after four straight sessions of gains, confirmed that a full recovery is not guaranteed. The market has been unable to cross the level of Nifty 3200, despite testing that several times in early July.

Although there was all-round buying last week, volumes were not particularly impressive and the market could stay indefinitely stuck in a groove between Nifty 3000-3200.
One shouldn’t make too much out of the derivative market signals this early in a settlement, but the August Nifty futures is trading at roughly 1% discount to spot and this is large enough to suggest that short-term expectations still remain rather bearish. So, it may have been just a relief rally rather than a renewal of faith by bulls.

The market was relieved that the RBI had not made a drastic rate hike in the wake of the interest rate hikes in the US dollar and Japanese Yen early in the month.
Nevertheless, a 25 basis point hike in reverse repo rates will translate into 50-100 bp, when it comes to prime lending rates and other commercial rates.

The pattern of rising rates started in the second half of 2004-05. At some stage, rates will rise enough to choke off demand for credit and slow down GDP growth. A 25 bp hike is certainly less damaging to banking than a bigger hike, though it is still a dampener. I think the banking sector will see another fall once the cooler heads in the market figure this one out. Despite strong technicals, the sector looks vulnerable in the context of the full year.

If the credit policy is to be believed, the RBI feels that most things remain on course. It is worried about the rise in global crude and commodity prices and apprehensive about “a disorderly adjustment in global currency markets”.

Translated from RBI-speak, this means it fears a period of turmoil in the forex markets.

The resources to protect the rupee from infection exist, given the $162 billion in reserves and capital account control. But the RBI is not averse to allowing an orderly depreciation.

In Q1 2006-07, if one goes by the declared results, the interest burden has risen by some 26%, compared to Q1 2005-06. However, sales and net profit has grown even faster in Q1 2006-07. So, the higher interest burden actually translates into a lower percentage of sales. The July rate hike will have its impact from Q2 onwards.

The smart money seems to be currently betting on big pharma stocks being outperformers in 2006-07. Cipla has its backers, as does Ranbaxy. Dr Reddy’s has delivered outstanding Q1 results and the stock has shot up. The cognoscenti are expecting big things from Aurobindo Pharma as well. Apart from pharma, the usual suspects such as the cement sector and IT, have delivered good results in line with expectations.

The uncertainties of gas supply for the Dadri mega project has already taken a toll on Reliance Energy. This story will continue to unfold with all the twists and turns one can expect from anything involving the Ambani brothers.

Stepping back from the details, note that internationally, gas prices align with crude prices and, hence, fuel costs are likely to be high through the foreseeable future. While India has a screwball pricing mechanism for what is called “APM gas” (administered pricing mechanism), it’s very likely that this would be benchmarked to international prices in the future.

The original Dadri projections assumed that RIL would deliver captive gas from the Krishna-Godavari basin for the project. Since that seems very unlikely, Dadri now has a big question mark attached to it. If that triggers a run on REL, life could become very difficult for the ADAG group.

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