Do it yourself

The conventional market wisdom suggests that the bonds usually lead the change in market cycles. Traditionally traders have closely followed the yield curve shape, benchmark (10 year) yields and high yield credit spreads to speculate the near term moves in equity, currency and commodity markets. Two simple reasons for this traditional practice are –

(i)    Bond markets are usually more correlated with the economy.

(ii)   Size of bond markets is materially larger than the equity, currency and commodity markets. It has the largest number of leveraged positions at any given point in time; and most of the large and influential market participants are more active in bond markets as compared to the other markets.

I am however inclined to disregard this piece of conventional wisdom. In my view, it would make sense only if the markets are operating in a free and fair manner. In cases where the central bankers and governments (through Sovereign Wealth Funds and other institutions controlled by it) actively and frequently intervene in the market, effectiveness of bond markets in leading the markets is impaired.

The world has definitely changed after the global financial crisis (GFC 2008-09). Central bankers, government, and public institutions are now playing significantly more active roles in the financial and commodity (especially gold and energy) markets. Bond prices are often influenced to suit the objectives of fiscal policy. Stock prices are influenced to suit political expediency.

Even pre-GFC, equity and bond traders did look at proxies like USD/CHF or copper—known as "Dr. Copper" for its economic sensitivity—for directional cues. In the past one decade we have seen Japan’s central bank buying equities; India’s government nudging markets via state-owned entities like LIC; the US Fed’s quantitative easing indirectly supporting massive amounts of stock buybacks; and Sovereign wealth funds in the Gulf Cooperation Council (GCC) countries piling into equities. This clearly indicates that in markets "no fixed formula works forever." Markets are adaptive. What held true for the past 35 years might not hold for the next 35.

US Bond yields no longer a lead indicator

In my view, the yield curve is fully relevant only if the market is free and genuine demand supply equilibrium of bond prices is discovered by the market forces. In situations where central bankers direct, manipulate or regulate yields, the yield curve is materially less important.

There is plenty of recent evidence, pointing that the US bond yields are no longer a strong indicator of the economy and/or markets. For example, consider the case of the US yield curve inversion in 2022-23.

Typically, an inverted yield curve—where short-term Treasury yields exceed long-term ones—has been a reliable harbinger of recession, preceding every U.S. downturn since the 1950s with a lag of roughly 6 to 18 months. The inversion that began in July 2022, peaking in mid-2023 with the 10-year/2-year spread hitting around -100 basis points, was the longest on record, lasting over two years. By historical standards, a recession should’ve hit by mid-to-late 2024. However, it has not happened; and the GDP growth held steady at 2.8% annualized in Q4 2024, and unemployment remains low at 4.1% as of March 2025.

Moreover, after un-inverting in September 2024—when the 2-year yield (around 3.6%) briefly dipped below the 10-year (around 3.8%)—yields have climbed across the board in the last two weeks. This morning, the 10-year yield is hovering near 4.5%, up from 4.0% in late March, while the 2-year has risen from 4.1% to about 4.5%. Incidentally, this rise coincides with a spike in recession odds, with the New York Fed’s yield curve model pegging the probability of a recession by mid-2026 at around 40%, up sharply from 25% a month ago. Normally, you’d expect yields to fall as recession fears mount, reflecting a flight to safety and anticipation of Fed rate cuts.

Prima facie, it appears that the bond market is more concerned about the rising inflationary expectations, particularly in light of the latest tariff policy of the US government. CPI is currently running above 3%—and there is skepticism about the Fed’s willingness to cut rates meaningfully from their current 4.75%-5.0% range. Higher yields also reflect a demand for more compensation amid uncertainty which could stoke inflation further. Arguably, the economy’s resilience—strong consumer spending, a robust labor market—may have also impaired the yield curve’s predictive edge this time. Structural shifts, like massive Fed balance sheet expansion since 2008 or global demand for long-term Treasuries, have certainly distorted its signal.

The recent yield rise despite recession odds implies that bond traders are betting on tighter policy or inflation risks, despite economic data flashing slowdown warnings (e.g., manufacturing PMI below 50 for months).

Conclusion: The yield curve’s relevance erodes when it’s less about market discovery and more about central bank glide path. Though it’s still worth watching, it’s no longer the king it once was in a freer market.

Tomorrow I will share my thoughts of what could be a better indicator, or aa mix of indicators to assess the likely market direction.

It was summer of 2013. The mood on the street was gloomy. The stock markets had not given any return for almost three years. USDINR had crashed 28% (from 53 to 68) in a matter of four months. GDP was on course to drop to 5.5% after growing at a rate of over 8% CAGR for almost a decade. Current account deficit had worsened to more than 6% of nominal GDP (the worst in decades). The Fx reserves of the country were down to US$277bn, sufficient to meet just 5 months of net imports. The confidence in the incumbent government had completely depleted. The people were on the street protesting against ‘corruption’ and ‘policy paralysis’.

The global economy had still not recovered from the shock of the global financial crisis (GFC). The thought of unwinding of monetary and fiscal stimulus provided in the wake of being unwound was unnerving most emerging markets ((Taper Tantrums), including India.

India, which was touted as TINA (There is no alternative) by the global investors just five years back and had become a key member of BRIC and G-20; was already downgraded to “fragile five” by some global analysts. This was the time when the government of the day took some brave decisions. One of these decisions was to appoint Mr. Raghuram Rajan, former Chief Economist and Director of Research at the IMF and then Chief Economic Advisor to the Government of India, as the 23^rd governor of the Reserve Bank of India (RBI). Mr. Rajan with the full support of then Finance Minister, P. Chidambaram, took several effective damage control measures, and was able to pull the economy and markets out of crisis within a short period of one year. USDINR gained over 11%, stocks markets recorded their all-time high levels, CAD improved to less than 1% of nominal GDP, real GDP growth recovered to ~7% (FY15).

The situation today is nowhere close to the summer of 2013. Nonetheless, the feeling is that we could potentially head to a similar situation in the summer of 2025.

Worsening external situation - rising global trade uncertainties due to the US unpredictable tariff policies, depleting Fx reserves, weakening USDINR, declining FDI and persistent FPI selling, pressure on the government to cut tariff protection for the domestic industry, and rising probability of a global slowdown.

Slowing domestic growth - Prospects of a poor Rabi crop aiding pressuring food inflation and RBI policy stance, crawling manufacturing growth, limited scope for any meaningful monetary or fiscal stimulus, etc are some of the factors that suggest the probability of any meaningful growth acceleration in the near term is unlikely.

Uninspiring policy response – The policy response to the economic slowdown and worsening of external situation is completely uninspiring so far. The measures taken by the government and RBI appear insufficient and suffer from adhocism.

For example, RBI has announced several liquidity enhancement measures in the past three months. These measures have been mostly neutralized by USD selling by RBI to protect USDINR and rise in the government balance with RBI (inability of the government to disburse money quickly to the states or spend otherwise. Risk weight cut for lending to NBFCs and MFI etc. is too little and too late. The damage to credit demand and asset quality in the unsecured segment is already done, and is not easily reversible.

The fiscal stimulus (tax cut on for individual taxpayers) could support the economy if at all, from 2H2025 only. There is a risk that the taxpayers in lower income segments (Rs 7 to 15 lacs) might use the tax savings to deleverage their balance sheets by repaying some of their high-cost personal loans etc. In that case this stimulus could have a negative multiplier on growth.

The short point is that (a) we are yet not in a crisis situation; (b) if not handled effectively and with a sense of urgency, the current situation may not take long to turn into a crisis.

The government, especially the finance minister and RBI, would need to urgently take several steps to take control of the situation and inspire confidence in the businesses and investors. Leaving it to the external developments, e.g., USD weakening due to falling bond yields in the US; energy prices easing due to Russia-Ukraine truce; trade normalcy restoration due to Sino-US trade agreement and normalization of Red Sea traffic; a plentiful monsoon easing domestic inflation; etc. may not be a great strategy - even if it works this time.

As they say – “it is great to have faith in God, but always lock your car”.

Continuing from my previous post (Bull fatigue or bear charge), I would like to share some of the important things I am presently watching closely to assess whether we are passing through a bull market correction or a proper bear market cycle is underway.

Rural income: The recent corporate commentary has highlighted green shoots seen in the rural demand recovery; while the urban demand continues to remain under pressure. For meeting the latest earnings estimates, continued recovery in the rural demand is, therefore, important. Earnings growth of some sectors like consumers, automobile, textile agri inputs & equipment, etc. materially depend on the continued rural demand recovery.

I note that there are some worrisome signs for the rural economy.

First, the 2024-25 winter has been unusually warm and dry. Several states have witnessed drought-like situations and warm weather. Reportedly, Wheat farmers in the northern regions could be staring at a sharp decline in rabi production. Some farmers are expecting upto 50% fall in wheat production due to warmer winter. Pulses and oilseed crops are also feared to be adversely impacted. (see here).

Second, present El Niño-Southern Oscillation (ENSO) weather forecasts are not indicating a strong preference for La Nina (excess rains) or neutral (normal rains) during the Indian monsoon season (July September). These conditions can change materially over the next three months. Given the importance of a normal monsoon for the Indian economy, especially the rural economy, ENSO developments need to be watched closely.

Liquidity: Banking system liquidity bears a good correlation with stock markets. Post Covid-19 monetary and fiscal stimulus resulted in over Rs12.50 trillion of surplus liquidity in the Indian financial system. This massive liquidity surplus resulted in a sharp surge in asset prices, especially stocks and real estate. That liquidity has completely dried. The Reserve Bank of India (RBI) has systematically withdrawn liquidity over the past couple of years. The system liquidity continues to be in deficit despite the measures (50bps CRR cut and Rs1.5 trillion sustainable liquidity infusion through OMO) taken by the RBI. (see here) A further USD10 billion three-year swap (buy/sell) has also been announced to augment the system liquidity.

However, even after these measures, system liquidity continues to be in deficit, as the RBI liquidity injection has been mostly neutralized by USD15bn sale in open market by RBI to check fall in USDINR; and the rise in the government balance with RBI. Given the persistent selling by FPIs in YTD2025 and worsening CAD, the pressure on USDINR may sustain. Under these circumstances, it is important to see how RBI manages to inject sufficient liquidity in the market. A change in policy stance from “neutral” to “accommodative” may be an important hint.

In the global markets, the US and Japan money supply (M2) has started to rise again in 1Q2025 after falling in 4Q2024; while the money supply in China remains at all-time high.

Inflation: The incumbent US President appears to be quite unpredictable. Regardless, his latest actions, in tandem with his commitment to safeguard USA’s economic and strategic interests at all costs, indicate that the US may impose sharply higher tariffs on imports from key suppliers like China, India, EU etc. These tariffs, if not fully absorbed by the suppliers through a mix of currency devaluation and margin adjustments, could be inflationary for the US. Consequently, we may see higher inflation, higher policy rates and bond yields and a much stronger USD. This could eventually be deflationary for the global economy as a whole.

A stronger USD and JPY, and higher bond yields, could result in further unwinding of carry-trades. Emerging markets economies and assets may face strong headwinds.

India, in particular, could be vulnerable due to slowing growth, expanding CAD, declining FDI, higher relative valuations (continuing FPI outflows), slowly depleting Fx reserve, and contracting yield gap with the US, etc.

A poor monsoon, on the back of below par Rabi crop, could halt the RBI easing cycle, as food inflation picks up and food import bill also rises.

It is therefore important to keep a close watch on the US trade policy, and the inflation trends.

Corporate earnings: the past couple quarters have been disappointing in terms of the corporate earnings, triggering a wave of earning downgrades. After the latest (3QFY25) results, Nifty EPS has witnessed 2-3% downgrade. If this trend continues in 4QFY25, the earning downgrades could accelerate. A leading stock brokerage firm (Kotak Securities) now expects Nifty EPS of Rs 1032 in FY25E, Rs 1179 in FY26E and Rs 1348 in FY27E with the Nifty trading at 22.2x FY25E, 19.5 x FY26E and 17.0 x FY27E.

The Nifty valuations are presently close to their long-term average (10yr). However, as another brokerage (nuvama) highlighted, most sectors are already close to their peak margin. Hence the prospects of a PER re-rating are remote, while PER de-rating are real.

In the past two weeks, three key economic events took place in India. These events aim to provide material fiscal and monetary stimulus to the economy.

In a keenly watched two-day meeting, the first after the inauguration of the new US President, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to pause its kept federal fund rates in 4.25%-4.5% range, after cutting it overall by 1% over its three previous meetings. The decision to pause is governed by a strong and resilient labor market and persisting inflation.

In a post meeting press interaction, Fed Chairman Jerome Powell noted that “The unemployment rate has stabilized at a low level in recent months, labor market conditions remain solid, and Inflation remains somewhat elevated.” He further added that the Fed needs to see “real progress on inflation or some weakness in the labor market before we consider making adjustments.”

Most notably, he emphasized that we're meaningfully above the ‘neutral rate’. He said, “I have no illusion that anyone knows precisely how much that is and but having cut 100 basis points means that it's appropriate that we not be in a hurry to make further adjustments.” (‘Neutral rate’ is a fed rate that is considered neither stimulative nor restrictive of growth under the current circumstances.)

Higher for longer: The market participants have taken this to imply that the current rate cut cycle is certainly not over and may resume after a pause, as the Fed gathers more evidence on inflation. Nonetheless, analysts now appear less sanguine about the lower bound of the present rate cut cycle. The consensus amongst them is emerging that the long-term bottom rate may have risen to 3% from the earlier estimates 2.5%. The ‘Fed pause’ is also being influenced by uncertainties surrounding the new administration's direction - on fiscal, trade, and government spending matters. The Fed officials noted “they don't intend to react until policies reach the implementation stage and begin to impact incoming economic data”.

Markets: Post the Fed decision, stock prices ended lower (S&P500 -0.5%), USD marginally stronger (DXY +0.2%) and benchmark bonds stronger (US 10yr Yield -0.37%).

RBI: The ‘Fed pause’ has made the February 06^th rate cut by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), less certain. There are however more chances that RBI may change its stance to ‘accommodative’ from ‘withdrawal of accommodation’, signaling now growth is a priority over inflation.

The Reserve Bank of India (RBI) recently released the results of its latest forward-looking surveys (November 2024 Round). Based on the feedback received from the respondents the survey results provide important insights with respect to consumer confidence, inflationary expectations and economic growth expectations.

Consumer confidence – Present tense, hopes high for future

The survey collects current perceptions (vis-à-vis a year ago) and one year ahead expectations of households on general economic situation, employment scenario, overall price situation, own income and spending across 19 major cities.

As per the survey results, Consumer confidence for the current period declined marginally owing to weaker sentiments across the survey parameters except household spending. The current situation index (CSI) moderated to 94 in November 2024 from 94.7 two months ago. (A value below 100 indicates a state of pessimism)

However, for the year ahead, consumer confidence remained elevated, improving 50bps from the previous round of Surveys. Households displayed somewhat higher optimism on one year ahead outlook for major economic parameters, except prices. The future expectations index (FEI) stood at 121.9 in November 2024 (121.4 in the previous survey round).

The respondents’ sentiments towards current earning moderated marginally, they displayed high optimism on future income which was consistent with their surmise on employment conditions. Households anticipated higher spending over one year horizon on the back of higher essential as well as non-essential spending.

Household inflationary expectations rise

Households’ perception of current inflation rose by 30bps to 8.4%t, as compared to the previous survey round. Inflation expectation for three months horizon moderated marginally by 10 bps to 9.1 per cent, whereas it inched up by 10 bps to 10.1 per cent for one year ahead period.

Compared to the September 2024 round of the survey, a somewhat larger share of respondents expects the year ahead price and inflation to increase, mainly due to higher pressures from food items and housing related expenses. One year ahead, the price expectation of households is closely aligned with food prices and housing related expenses.

Male respondents expected relatively higher inflation in one to three months, as well as one year ahead, as compared to the female respondents.

GDP: Real gross domestic product (GDP) is expected to grow by 6.8% in 2024-25 and 6.6% in 2025-26. Forecasters have assigned the highest probability to real GDP growth in the range 6.5-6.9% for both the years 2024-25 and 2025-26.

Annual growth in real private final consumption expenditure (PFCE) and real gross fixed capital formation (GFCF) for 2024-25 are expected at 6.2% and 7.9% (revised down), respectively. Real gross value added (GVA) growth projection has been revised down marginally to 6.7% for 2024-25 and kept unchanged at 6.4 per cent for 2025-26.

 Inflation: Annual headline inflation, based on consumer price index (CPI), is expected to be higher at 4.8% for FY25 and 4.3% for FY26.

External sector: Merchandise exports and imports are projected to grow at a slower rate of 2.4% and 4.6% respectively in FY25 and recover to 5.5% and 6% respectively in FY26, in US dollar terms. Current account deficit (CAD) is expected at 1.0% (of nominal GDP) during both FY25 and FY26.

Notwithstanding a marked slowdown in the past few quarters, the Indian economy has managed to grow at a decent pace in the current global context. Though India may have lost the crown of the fastest growing global economy to Vietnam, it still remains the fastest growing amongst the top 10 global economies.

The Reserve Bank of India is holding US$658bn in forex reserves, which is considered adequate in normal circumstances or even in a usual cyclical slowdown. Despite accelerated selling in equity markets by the foreign portfolio investors (FPIs), the current account deficit of ~1.5% of GDP, is conveniently manageable. INR has been one of the most stable emerging market currencies. On the real effective exchange rate (REER) basis INR is presently ruling at a five-year high level.

In their recent policy review, the Monetary Policy Committee (MPC) of the Reserve Bank of India has cut growth estimates for FY25 by 60bps to 6.6% and 1QFY26 by 40bps to 6.9%. The MPC has also hiked their inflation forecast for 2HFY25 and 1QFY26. The RBI estimates are still few basis points higher than the average estimates of professional forecasters, as per the RBI’s recent survey. It is therefore likely that growth slowdown extends well into 1HFY26.

RBI has once again made it clear that it is not comfortable about the inflation trajectory and would prefer to outweigh price stability against growth in its policy dynamics. In the recent meeting, the two external members of the MPC voted in favor of a 25bps repo rate cut, but the RBI’s official nominees voted to maintain a status quo, despite loud growth concerns and political rhetoric for monetary easing.

The market consensus seems overwhelmingly in favor of a February 2025 repo rate cut. This assumes growth staying in the slow lane; lower food and energy inflation; and fiscal improvement as promised in the union budget for FY25. We need to watch for development of La Nina, adversely impacting the Rabi crop; slowdown in tax collection and rise in cash subsidies due to election promises adversely impacting the fiscal disincline. Compensating higher subsidies with a cut in capital expenditure (as has been the case in 1HFY25) would further slowdown the potential growth, making any monetary easing more inflationary.

At the surface level there is nothing that would ring alarm bells for domestic investors. However, some of the recent actions of the RBI are reminiscent of the 2013 crisis period. The monetary policy is increasingly sounding like a plan to secure the stability of USDINR.

I wonder if RBI is really worried or it is just cautious and taking preemptive steps to mitigate any chance of a balance of payment crisis and/or currency volatility.

I have taken note of the following data points; and at the risk of being labeled unnecessarily paranoid, I would keep a close watch on these for the next few months to assess any vulnerability in India’s external sector.

·         There has been a marked slowdown in foreign flows -both portfolio flow and FDI flows in the past one year. The political changes in the US and Europe may further impact the flows in 2025. RBI may not want to further discourage flows by offering lower bond yields. For record, the India10y-US10y yield spread has already fallen from a high of 350bps in January 2024 to ~250bps.

·         RBI has created a record short position in USD (over US$49bn in forward market) in the past couple of months to protect USDINR; besides running down Fx reserves by ~US$47bn in just one month (from US$705bn in October 2024 to US$658bn in November 2024)). It has taken almost US$96bn to keep USDINR stable in the 83-50-84.50 range.

It is critical to watch this because:

The global trade war could escalate, before it settles after the inauguration of President Trump. This could slowdown global trade; lead to China dumping on non-US trade partners; slowdown in remittances and services exports to some extent.

As the denominator (nominal GDP) goes down and exports also slow down, the current account deficit may show a tendency to rise, pressuring INR. The RBI cannot afford to spend another US$100bn on defending USDINR.

RBI has hiked the ceiling on interest rates offered by scheduled commercial banks on foreign currency deposits of NRIs. This is an early sign of the RBI worrying about Fx reserves. Any measure to limit foreign spending, investments (outward FDI) and LRS remittances will confirm these fears.

Presently, FPIs own about US$650bn worth of Indian equities, which is equal to official fx reserves of India. A US$12bn (appx 1.75% of total holding) sale in the past couple of months has caused some damage to the market sentiments. A 5% selling (US$35bn) could seriously damage equity markets, currency markets and RBI’s gameplan. Remember, on an average, we are running a ~US$20bn/month trade deficit; and a net external debt of over US$682bn. In a crisis situation, US$658bn reserves might not prove to be adequate.

·         President-Elect Trump and some of his designated team members have explicitly termed India a “currency manipulator” and demanded RBI to strengthen USDINR. If RBI is forced to meet these demands, it may need to unwind its short USD position, conduct aggressive OMO to buy USD from the market, and engineer higher yields (bond and/or deposits) to attract more USD flows into India. This could make maintaining current account balance a challenging task. Especially in an environment, where China could be dumping everything in the global markets, and competitors like Vietnam, Indonesia, Philippines, Turkey are becoming very aggressive.

If you find it confusing, impertinent, misplaced, let me sum this up in short for you. I would prefer to totally avoid macro trades in 2025, and stay committed to individual business stories that I like.

The 3-day bi-monthly meeting of the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) begins today. This would be the last meeting before presentation of the Union Budget for the year FY26. The members of the MPC would draw inputs from the latest national accounts (2QFY25 GDP data); October 2024 inflation data; October 2024 Professional managers’ survey results; September 2024 IIP estimates; November 2024 PMI and core sector growth data; April-October fiscal balance data; global developments (political and geopolitical); global inflation, rates, currency and market trends; expert opinions and views of the members of MPC; and assessment of the current and future situation provided by the staff of RBI.

The statement of the MPC on macroeconomic outlook and likely direction of the monetary policy will be a key input in preparation of the Union Budget for FY26. However, the market participants’ interest in the MPC meeting appears limited to whether, or not, at 10AM on 6^th December 2024, the RBI governor announces a repo rate cut and/or a cut in the cash reserve ratio (CRR). Some TV show panelists might also bother to note the downward revision, if any, in the growth estimates for FY25.

If the MPC decides to maintain a status quo on its policy stance – considering growth slowdown a temporary blip expecting a recovery from 3QFY25; and continue to accord higher weightage to still elevated inflation and highly uncertain and volatile global conditions, the market participants may be hugely disappointed.

Not to cut: In the October policy statement, the governor had adequately hinted about its preference for price stability over growth (see here). Perhaps RBI is much more conscious about the looming external threats, especially the balance of payment situation if there are sudden FPI outflows; or the FDI flows get restricted; or remittances are affected.

Or to cut: In the recent weeks, RBI has allowed USDINR to sustainably breach 84 mark. It appears that it may want USDINR to weaken further before Trump takes over the US presidency on 20^th January, and urges its trade-surplus trade partners to strengthen their currencies. We have seen a similar weakness in USDCNY also, for example. A token 25bps or an aggressive 50bps rate cut could drive USDINR to 86 in near term, providing RBI a leverage to engineer a ~5% USDINR appreciation to ~83 level in the next three months.

In either case, the transmission of the lower rates may not be in the corresponding measure, as RBI might continue to control credit growth and liquidity to reign inflation, asset quality and excessive unsecured lending. I therefore would not expect a CRR cut. I am however mindful that the market is pregnant with the hope of a CRR and/or repo rate cut and no action in this regard may lead to a sharp sell-off in financial stocks, especially NBFCs.

The market participants may also take note of the following three potential near term risks:

·         Besides the real GDP growth, the nominal GDP growth has also fallen to 9% in the 2QFY25. A lower nominal GDP growth directly impacts the tax collections and corporate profitability. November manufacturing PMI is at 11 months low. Core sector growth has also been low in 3QFY25. Expecting an immediate revival of growth in 3QFY25 may not be prudent; and the RBI may not mind a transitory higher inflation to boost nominal GDP growth.

·         The president-elect Trump has explicitly threatened the BRICS nations to refrain from any misadventure that would impact supremacy of USD. It may purely be rhetorical to gain some upper-hand in trade/sanctions negotiation with Xi and Putin. Nonetheless, it could cause higher volatility in the global markets. It becomes critical given that BRICS members supply two thirds of global fossil fuels.

·         The outgoing president Biden has provided a complete pardon to his son, who was facing multiple criminal charges in the US. Biden had earlier categorically denied this favor to his son. Experts are interpreting this as an indication of rising fear of a widespread witch hunt by the Trump administration. The witch-hunt, if it does take place, may not remain restricted to the domestic political opponents of Trump. 

Last weekend, I happened to meet a senior IT professional, aged 48yr. This gentleman has worked with many global IT services companies like IBM, Google, etc. He has his wife and two teenage daughters in his family. Four years ago, he quit his job and took to equity and derivative trading as his full-time occupation. He even developed an algorithm of his own for trading in options. He did very well till March 2024, earning an IRR of over 54% on his capital deployed in the trading business. With a material growth in his earnings, his lifestyle changed dramatically. He bought a bigger house, bought a luxury sedan for himself and a car for his daughters' use. They travelled business class on their Europe and America trips.

In April 2024, he grew in confidence and increased his exposure materially, deploying all his savings in the market. In the past 6 months, he has lost 70% of his enhanced capital in option trading; and is close to defaulting on his house EMI. The losses in the market are not his primary worry presently. He is more concerned about convincing his family for a downgrade in their lifestyle.

After discussing various aspects of his problem, I concluded that he may not be an isolated case. There may be hundreds of other full-time traders who have witnessed this ‘wealth effect’ in the past 3-4 years and may be fearful now.

Wealth effect

Arthur Pigou, an American economist, coined the term “the wealth effect” in a 1943 article. The idea was to measure the changes in consumption based on the change in the values of housing and financial assets. He argued when asset values are high consumers feel wealthy and go shopping: when asset values are low consumers slow spending. As a result of the concentration of American wealth in home equity, the level of housing prices can dramatically impact consumer confidence.

Daniel Cooper (Federal Reserve Bank of Boston) and Karen Dynan analyzed the Wealth Effects and Macroeconomic Dynamics in a 2016 research paper. The paper stated that “The effect of wealth on consumption is an issue of long-standing interest to economists. The relationship is particularly important from a policy perspective, given the large swings in financial asset prices and property values over the last few decades in both the United States and many other developed countries. The conventional wisdom is that the resulting fluctuations in household wealth have driven major swings in economic activity. Indeed, the plunge in asset prices during the financial crisis is frequently cited as an important contributing factor to the unusually slow economic recoveries in the United States and some other developed countries. Similarly, the large drop in asset prices in Japan following their peak in 1990 is viewed as having restrained growth during the subsequent decade in that country.”

The paper also highlighted that a great deal of empirical research over the last 25 years has focused on the so-called wealth effects – the impact of changes in wealth on household consumption and the overall macroeconomy. The research has yielded some important findings about the nature of household wealth effects, but consensus has yet to be reached on many important issues.

The authors concluded that “Understanding wealth effects is critical not only for forecasting consumption and broader economic growth well, but also for gauging the risks to the economic outlook and setting appropriate macroeconomic policy. Such issues are particularly important during periods of large fluctuations in asset prices.”

I could not find any noteworthy research related to the wealth effect specifically in the Indian context. However, anecdotally we can find several cases like the gentleman referred to earlier in this post. In my view, the policymakers in India need to take cognizance of the wealth effect generated by the supernormal returns from the equity investments and real estate in the past four years.

I also note, in this context, the outcome of the latest Consumer Confidence Survey (CCS) of the RBI. Despite several headwinds in terms of slowing growth, rising cost of living, slower real wage growth, and challenging employment environment, and pessimism about the current situation, the consumers’ future expectations remain optimistic. This might send erroneous signals to the policymakers, producers, sellers and service providers.

I shared some of my random thoughts with the readers last week (see here). Many readers have commented on my post. Some readers have raised some pertinent questions and also provided very useful feedback. Based on the readers’ comments, questions and feedback, I would like to share some more random thoughts. It is however important to note that I am a tiny insect living in a cocoon of my own. I cannot comment intelligently on the international markets, policy matters and geopolitics. Nonetheless, I reserve my rights to form strong views on global and domestic developments concerning markets, policies and geopolitics, for my personal strategy purposes.

The US debt end game

The current state of the Fed balance sheet and the US public debt is certainly not sustainable by any parameter. It is a matter of debate how the US government and the Federal Reserve would make fiscal and monetary corrections and eventually return to an acceptable level of public debt without pushing the economy into a deep recession (hard landing). One of the most talked about resolutions to this conundrum is to keep bond prices lower and buy back aggressively over the next few years. That may be one of the easiest ways to return to fiscal sanity. Creating an artificial shortage of USD and forcing UST holders to sell cheap could be one of the means to achieve this target. To create USD shortage, a reverse carry trade might be induced, by narrowing the yield spreads, besides reducing CAD through tariffs and other trade restrictions.

For context, the US is running a quarterly current account deficit in excess of US$260bn; a fiscal deficit of over US$1.7trn (2023) and USD supply (M2) of over US$21trn. The US GDP was US$27.4trn in 2023, accounting for roughly 26% of the global GDP.

The great gambler

The RBI governor's job in India might be the most unenviable one. He has to struggle 24X7 to maintain a balance between fiscal requirements, political consideration (inflation and small saving interest), growth needs (real rates) and balance of payment (USDINR exchange rates). Repo rate and open market operations are the only two major tools available to him.

The RBI has been maintaining a status quo on the repo rates for over a year now. This has sustained the US-India yield gap (to protect flows) to some extent, but the efficacy of high repo rates in ensuring price stability, which is the stated primary objective of the RBI’s monetary policy, is questionable. Besides, the RBI has been meaningfully enlarging its balance sheet in the post Urjit Patel era, while stated policy objective, until the last week, has been “withdrawal of accommodation”. This aspect is not talked about much in the public domain. One may speculate that the real objective of the RBI’s monetary policy has been to prevent USDINR appreciation (even if it means high imported inflation) and ensure sufficient inflow in small saving schemes, which are funding almost 45% of the union government’s fiscal deficit. It has been obviously playing a gamble with high stakes, US$700bn forex reserve notwithstanding.

 Indian lenders face challenges

The persistent negative credit deposit ratio of Indian banks has been a subject of discussion at all levels. The government, regulators (RBI and SEBI), bankers and analysts etc. have all expressed concern over the poor deposit growth, while the credit demand remains strong. The finance minister and RBI have even attributed the flow of funds towards capital markets as one of the reasons. In my view, high household inflation, poor real wage growth and very low real rates on deposits are the primary reasons for this trend. Besides, for most lenders the asset quality improvement trend that started five years ago may have already peaked.

I feel most Indian lenders may now face three challenges – declining margins as the cost of funds rises; flat to declining asset quality and slowing growth. Investors are cognizant about these challenges but as the response to a recent IPO of a housing finance company indicates, they may not have yet adjusted their respective investment strategies.

Focus on finding opportunities

As a wise man suggested, the small investors like me should not be wasting energy on bothering about these macro things and focus on finding the investment/trading opportunities which may be opened by policy missteps, fund flows, geopolitical tensions etc. I fully agree with this thought. For the next 4-5 months, I shall be focusing on finding opportunities and taking advantage of traders’ mistakes.

The Reserve Bank of India (RBI) has issued its latest assessment of the state of the economy. The paper notes the marked slowdown in the global economy; it exudes confidence in the sustainability of 6.7%-7% GDP growth in India. In particular, the assessment sounds buoyant on manufacturing, and household consumption, while taking cognizance of resilience in the services sector. The inflation is forecasted to stay close to the lower bound of the RBI tolerance limit (4-6%).