The Truth Behind Numbers

Net capital flows by FIIs have a high positive correlation of 0.67 for the past one year, improving from 0.65 of the past three years. The second biggest contributor to the Sensex movement is the interest rate differential (spread) between RBI repo and the US federal discount rate, which has a high inverse correlation (0.46). The Sensex PE is determined more by the spread between the RBI repo and US federal discount rate with a high (0.49) inverse correlation. The GDP, IIP, corporate sales and EBIDTA margins have very low, if not no correlation with the Sensex gyrations. It is also observed that IIP data may move the Sensex for a day or two. However, over a five-day period (from one day prior to five days after data release), on many occasions, the Sensex rises despite down-tick in IIP and vice versa.

We have undertaken a regression analysis of data spanning a period of 22 quarters on BSE 500 net sales, GDP, IIP, net FII flows, crude oil prices and spread between the RBI repo and the US federal discount rate.

The Bigger Picture

Inflation, which has a very high correlation with the spread (between 10-year GoI and US sovereign securities), imply that higher the spread, higher the inflation in India. The spread currently is 469 BPS against 287 BPS about two years ago. Our regression analysis shows that the rupee is at the mercy of the central bankers’ policy of stretching the spread. A widening spread between the two sovereign securities squeezes the rupee, thereby hurting corporate growth and profitability. The INR/USD correlation with the spread between yields has been 0.50 over the past one year. The rupee had negative correlation with stable spread and also saw smart appreciation.

The net FII flows ameliorated the movement in Sensex from June 2006 – Oct 2007, with record inflows of Rs 18,949 crore during Sep 2007. Due to the sub-prime tremors and crisis in the US credit markets, FII outflows increased dramatically from Nov 2007, thus dragging the Sensex down. Currently, the spread between repo and the federal discount rate is 625 BPS, and has doubled from 350 BPS over a span of just seven months.

The collected data shows that the narrowing spread brought investors’ confidence into the Indian market, which gave the Sensex its momentum. The Sensex had been on a roll when the spread was 75 BPS during the period March to September 2006. The recent credit market crisis has widened the spread pulling down the Sensex.

One of the reasons why IIP does not exert much influence on the Sensex is that some of its constituents and/or their assigned weightages are way outdated. In the absence of accurate essential ingredients, the market relies more on the liquidity drivers. Therefore, it can be deduced from the above analysis that IIP and sales have a low influence on the index.

Rupee Movement

The rupee ‘appreciates’ stable and lower spread and depreciates when the spread widens. When the spread was stable in lower single digits, it had high negative correlation with the change in the foreign exchange rate of the rupee. A stable spread brought enormous confidence in the country’s fiscal management and attracted dollars from foreign portfolio investors as also FDI. Highly correlated spread, widened by different policy compulsions of two different governors, has brought bears on Mint Street to launch an onslaught on the rupee. The correlation between the rupee movement and the spread is (0.50). This information would help investors to know how to react to economic numbers.