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Tuesday, July 28, 2009

Are the stock and currency markets interdependent?

The BSE Sensex index continues to move in a sideways consolidation range between 13500 and 15600, apparently unaffected by the RBI's recent policy announcement of keeping interest rates unchanged.

A prolonged period of sideways movement puts investors in a quandary. Those who missed the rally are itching to get in. Those who were smart enough to invest at lower levels are sitting on big profits, but worried about a crash around the corner.

This is a good time to do nothing - as far as transacting in the stock market is concerned. Use the lull period to do research on individual stocks and brush up on the fundamentals of money supply and how they affect different markets.

The short answer to the question is: Yes, both markets are interdependent locally and globally. The long answer follows.

There is little direct relationship - most of it is through indirect effects of money flows, global businesses, inflation rates and interest rates. It may not be out of place to mention here that the forex market is massive, about $1.5 Trillion per day - a week's trading is equivalent to twice the annual turnover of the New York stock exchange! Interested readers may want to read this article.

Think about the Dow, which had a strong rally last week. Investors from outside the USA, whose domestic markets may not be performing so well - France, for instance - may decide that it is time to enter the US market.

They convert a sackful of euros into US dollars. Depending on the size of the sack, the euro will go down in value relative to the US dollar. May be currency traders figure out that some thing is going on and start to buy US dollars and sell euros.

Investors in Germany decide to join the party. More euros are sold to buy dollars to invest in the US market. With foreign investors pumping in money, both the dollar and the Dow start to rise, as the euro drops.

The opposite happens if the Dow tanks. Foreign investors pull out of US stocks, convert dollars to euros that makes the euro appreciate and the dollar depreciate. The logical conclusion should be that the level of a stock index is directly proportional to the value of the underlying currency.

But it is more complicated than that. Let us take the example of CocaCola. It now sells more outside the US than within the US. For argument's sake, let us assume that the bulk of its sales are from the euro countries. If the dollar tanks and euro appreciates, CocaCola's US sales and profits may suffer but their higher euro-zone profits will more than cover the gap.

CocaCola may declare better Q2 profits, as may IBM and Microsoft and others if they sell more in the euro-zone. End result? The Dow may shoot up if the index components make super profits, while the dollar tanks.

With FIIs pumping in money, the BSE Sensex index nearly doubled from its Mar '09 lows. Logically, the Rupee should have gained against the US dollar. But it is at a lower level now than a year back.

I have a couple of questions for readers:

Why do you think the Rupee depreciated when the Sensex went up?

Why do you think the RBI left interest rates unchanged?

(Thanks to reader Rajeev, for suggesting that I write something about the interdependencies of the different markets. This post is already too long. I plan to write about the bond market and commodities market in future posts.)

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Anonymous said...

Hello Sir,

I think rbi didn't raised interest rate b'cos it will hamper growth, just b'cos cost of capital will increase, and it also didn't lower interest rate b'cos it will induce excess liquidity in system, but i read someware that govt. is giving intensive which are similar to reduction of 50 basis point in crr per month (?)

about ruppies deapperciation last year it was around 40 ( 38 at dec 2007) and few month back it was 52now it is 48, i think after march money came to india which pull Rs to 48 from 52

please guide me where ever i am wronge

Anonymous said...

Hello Sir,
in my previous post i mentioned something which source i was not remembaring that time, it is credit suisse report which says, rbi is injecting liquidity in system (not by reducing rate) which is equivalent to 50bp per month in crr (9% of gdp)

SG Money Mind said...

My take on why RBI left the interest rate unchanged is, there is sufficient liquidity in the banking system and instead of giving out loans, (or because there is not sufficient demand from the corporate) banks are parking their excess money in the gilt.

By cutting the interest, RBI would have added further liquidity into the system. Vice versa, if RBI had increased the interest rates, banks will pass on the interest rate to borrowers, which is against the objective of the government (or RBI), at least for the time being.

So doing nothing was a better option, taking into consideration the benign inflation situation (excluding CPI) as it exists now.

Subhankar said...

Hi Titu and SGMM

Appreciate your inputs. Both of you have read the situation correctly.

FIIs poured in US $2.3 Billion in July '09. That should have led to an appreciation of the Rupee against the Dollar.

But it didn't. That tells me RBI is probably intervening and buying Dollars to help exporters.