Looking Out Across The Horizon

Since the Greek/Euro crises broke out in earnest some time last month, the German Bunds and US Treasuries have seen increasing demand (and falling yields) as people pull out money from “risky assets” and park them into “safe havens”. This has been the typical behavior in all recent panics, but somehow, this time around it makes little sense to me.

US 2-year treasuries are currently yielding about 80 basis points (or 0.8% per annum). Not only is this ridiculously low for ordinary times, it sounds even worse given the extent of Quantitative Easing being undertaken by the Federal Reserve. As the Fed puts more and more money into circulation, I’d expect severe inflationary pressures; or equivalently for international investors, a severe deterioration in the value of the US Dollar. Except against the Euro. Which brings me to the German Bunds. The case of German Bunds is even more baffling. The reason why German Bunds are in favour right now is because of panic for the Eurozone and the Euro itself. In my mind, that is precisely the reason why German Bunds are a bad investment, particularly at low yields of 2.65% p.a. for the 10 year bond. With a currency facing potential deterioration of 20% or more (the Euro hitting parity with the US Dollar is an oft-discussed possibility), why would someone invest in a fixed income security yielding 2.65%? One reason would be that for a lot of institutional investors in the Euro-zone, investing all (or most) of their corpus in European instruments might be mandatory. They have nowhere else to go and so they buy debt from the least-likely-to-default Eurozone country. But what about others? I’d imagine that they should be buying commodities and gold. That is probably the only safe bet at this point.

Gold indeed seems to be attracting massive attention as it reversed it recent short downtrend and is back at $1215 per troy ounce having fallen to $1170. In Rupee terms, the story is much worse with prices reaching new highs of over Rs. 18,600 per 10 grams. It is here that I think there is some madness again. Part of the reason why fresh highs are being made in INR terms is the bulk pulling out of FII investments from the equity market, which is pushing down the INR against the USD. So while I remain bullish on gold in USD terms, I have mixed feelings about it in INR terms, mostly because I see INR weakness as only temporary and would expect a reversal if/when saner minds take over the market and money flows back out from the insanely over-priced US treasuries and returns to economies where genuine growth is taking place and long-term investors can get the biggest bang for their buck.

Of course, I don’t expect sanity to return too soon and I’d expect to see the INR trade atleast between 49-50 to the Dollar before money flows back in.

The fall Gold has taken from its recent high of about $1248 to a current level of $1170 is baffling. That is not to say that it hadn’t taken a real run-up over the previous few weeks. The point is that while equity markets continue to head south and US Treasury and Bund yields continue to get compressed, Gold, which should be the ultimate inflation/currency hedge is also taking the fall. Over the week ended 14th May 2010, I had expected one of two things to happen. One, Gold continues to head higher/stays stable at 1230-1250 levels while equity markets rise on low volumes. Such a scenario would have been a good time to sell into the rising equity market as Gold as a sentiment barometer still reflected serious risk-aversion. The other scenario would be a rising equity market with falling Gold. That would probably be a sign of recovery, or at least an improvement in sentiment and so the equity rally could be sustainable. Nothing, however, had prepared me for a falling equity market with a simultaneously falling Gold price.

From the Indian perspective, however, things make more sense as the recent Gold fall in USD terms has hardly translated into a fall in INR terms, while the benchmark stock market indices continue to fall. The principal reason is of course the departure of FII money from the equity market, which pushed the USD higher against the INR.

My own view is that this flight of capital into “safer” US Treasuries is the expected short-term behaviour. However, once things settle down into the “new normal”, whatever that may be, we should see a significant return of overseas interest in the Indian (and other Emerging) Markets. Unless we hit another wave of “irrational exuberance”, I’d expect capital to flow to countries with more transparent administrations, stronger enforcement of property rights and more predictable regulatory environments*.

The EUR/USD pair has also shown puzzling behaviour overnight with the EUR rising back from a low of below 1.22 back to 1.26 overnight. One explanation is the given the major Swiss National Bank intervention for defending the Swiss Franc, the ECB might do the same for the Euro. The shorts probably covered their positions and took their profits home. A fresh wave of panic might push it down again soon enough, though. The other important point is that we tend to forget that this is a currency “pair”. Two months ago, EUR/USD was a proxy for the USD against “a foreign currency”. Over the last two months, that changed into a proxy from the Euro against the world. However, given that things don’t look good either for the Eurozone or for the US, the pair is now looking like a see-saw trying to figure out which one goes down first, and harder. We should be finding out soon enough.

* The recent recommendation by the TRAI for linking the 2G spectrum fees to the bids received for the 3G spectrum are just one example of the regulatory unpredictability in India. Particularly for industries with hugh capital requirements like telecom, such fickleness would scare away a lot of long-term investors. Such behaviour needs to be kept in strict check if we want to be the preferred destination for foreign capital.