Structural liquidity still in deficit

Samvat 2075 started off on a positive note with India's key stock indices gaining sharply in limited muhurat trading. Democrats gaining control of the House was another reason to buoy global indices, particularly the US markets, during a week where the US Federal Reserve held rates steady with a guidance of a possible hike in December. The major event of the week was a sharp drop in crude prices. Volatility Index (VIX) remained soft and benchmark US yields moved lower in response to an expected Federal Reserve rate decision.

The US midterm elections threw a surprise as Democrats appeared to be gaining control of Congress and this could keep the Trump administration in a tight spot until the next elections. Legislative gridlock appears to be the way forward and historically, US stock markets have rallied after midterm elections.

However, the current developments both on elections and political discussions front will eventually be overshadowed by more fundamental economic factors and macroeconomic policies. In the macro policy side, the FOMC (Federal Open Market Committee) kept rates unchanged and it looks fairly likely that a December hike could well be a high-probability decision.

The US crude prices fell after reaching a four-year high in early October as uncertainty surrounding global growth and rising production exerted pressure. In addition, the US administration's recent decision to issue temporary waivers to eight countries for importing Iranian Oil and rising US oil inventories also exerted downward pressure on crude prices. There is also an important market phenomenon, where the yield on two-year US Treasury note, now at its highest level in 10 years, is a prognostic tool for economic activity. When the yield on the two-year note has risen sharply as now, it has led to a slack in economic growth. Higher rates are often seen as encouraging savings and discouraging capital investments. This fact is also borne by Federal Reserve officials note after the policy decision that business investment has moderated from its rapid pace of growth earlier this year.

Indian markets had a very shortened week of market activity as festival holidays saw two days' holidays. Stock markets continued their trudge higher while bonds saw strong buying interest with yields remaining sub-7.80%. The Indian rupee continued to gain driven by a general dollar weakness against major currencies and a drop in crude prices. The weeks ahead may see volatility returning to the Indian markets as state election results could be seen as a precursor to the trend in federal elections later in mid-2019. Apart from the election results, the week ahead sees the release of domestic inflation data, both WPI and CPI, and Industrial Production data for September. Inflation is expected to return a softer reading and will be a key factor for the MPC's rate decision later in December.

While bonds have seen broad-based buying interest, liquidity will be a key determinant in the days ahead. Structural liquidity is still in deficit mode and once the entire open market operations (OMO) flow hit the system this month, the deficit will be close to neutral. The yield on the benchmark 10-year note should test 7.70 in the near-term where profit taking should kick-in. 7.75-7.85 yield should otherwise be the preferred range in the week ahead.

VOLATILITY AHEAD

• Weeks ahead may see volatility returning to the markets as state election results could be seen as a precursor to the trend in federal elections 
   
• While bonds have seen broad-based buying interest, liquidity will be a key determinant in the days ahead

The writer is a market expert