GalaTime

• Bloomberg: Merrill Says India’s Swaps Signal More Rate Increases

Two-year swap rates in the past week climbed the most since the derivatives started trading in 1999, signaling that Reserve Bank of India Governor Yaga Venugopal Reddy may raise repurchase rates to the highest since 2001.

Two-year swap rates surged 1.3 percentage points in the week through yesterday to 9.86 percent, while contracts for five years climbed 1.2 percentage points to 9.9 percent.

The five-year swap rate is 1.45 percentage points above the central bank rate, compared with a median of 23 basis points over the past four years.

• Economic Times: Gold ends at $912.60/913.60 as funds buy, oil soars

Gold ended nearly 4 percent higher on Thursday with funds pouring into commodities as a tumbling stock market amid oil’s surge to a new record high boosted bullion’s appeal as an alternative investment.

. . . the dollar extended losses against major currencies as expectations for a U.S. rate hike receded after comments from the Federal Reserve on Wednesday.

Oil, the other main external driver of the gold price, surged 4 percent to a record $140.39 a barrel.

• Safe Haven: When Central Bankers Clash, Stock Markets can Crash

Central bankers of fast-growing emerging economies are navigating through the stormy seas of commodity inflation by tightening monetary policies. But the “Group of Seven” central bankers have acted in a different fashion. The British, Canadian, and US central banks are focused on the global banking crisis, and the slide in US home prices, and have lowered their interest rates, while the Bank of Japan has stood motionless. But the European Central Bank was moving in the opposite direction, and guided Euro-zone money market rates to their highest in 7-years.

The downward spiral in the German bund market widened the Euro’s interest rtate advantage over the US dollar, leaving the greenback on shaky ground and vulnerable to speculative attack. Bernanke would be under heavy pressure to match a second ECB rate hike to 4.50%, to defend the value of the dollar. In essence, the ECB could hijack US monetary policy, and force the Fed to guide the federal funds rate higher, in order to shake-out speculators in the crude oil and commodities markets.

Note that major US indices dropped over 3% yesterday, and Asian markets are following suit this morning. Do we see 4000 on the Nifty soon?

• Financial Times: GaveKal’s four ways to make money

. . . how money managers can make money in the current conditions -

1. Run some kind of momentum trade

2. Run some kind of return to the mean trade

3. Run some kind of carry trade

4. Run some kind of negative carry-trade

• Via Big Picture, Welling @ Weeden: Inflation Not The Problem

The Royal Bank of Scotland Group Plc (RBS LN) has the largest rights issue in European history, and everybody cheers it! It makes no sense. As I wrote, it’s the financial equivalent of being mugged and turning around and saying, “Thank you. But should we head off to the cash point so I can give you some more?”

Emerging markets are trading on a 40 times cyclically adjusted P/E. Back in 2003, they were at 10 times cyclically adjusted P/E.

If you’re investing in commodity futures, which most of theses funds tend to do, it used to be that the market was generally in backwardation, so you collected a positive roll on your contracts. But now, because these guys have driven up the spot prices so much, a lot of these markets tend to end up in contango, which means you get a negative roll. That means that you’ve got to make 15%-16% per annum in price move — just to cover the negative roll.

• Bloomberg: India’s Pro-Growth Lobby Squirms as Rates Rise

The Associated Chambers of Commerce and Industry of India, which in October conducted a survey of chief executive officers and said the “stage is set for the RBI to relax monetary policy,” is now singing a different tune. Higher interest rates would hurt, it said in a press release yesterday, “yet the pinch will be less painful than double-digit inflation.”

. . . high prices are being passed on to the consumer because of strong local demand, which must be cooled with monetary measures.

. . . businessmen in India can’t get over the ghosts of 1997. Then, too, interest rates were high, and a fast- growing manufacturing economy had first slowed and then descended into a multiyear funk.

Say 7% GDP growth. Assume a generous 15% EPS growth - that would take the Nifty EPS from 235 to ~ 270. At a P/E of 14, that works out to 3800 - one year from now. Ouch!

• Business Standard: RBI`s double whammy makes India Inc see red

RBI raised the repo rate, or the rate at which it lends to banks, by 50 basis points to 8.50 per cent. The cash reserve ratio, or the proportion of deposits kept with the central bank, will be increased by 50 basis points to 8.75 per cent.

While the repo rate has been increased to 8.50 per cent with immediate effect, the CRR hike will be implemented in two phases: To 8.50 per cent from the fortnight starting July 5, and to 8.75 per cent from July 19.

. . . aggregate deposits rose 23.2 per cent year-on-year on June 6 against the indicative projection of 17 per cent for 2008-09. Similarly, non-food credit grew 26.2 per cent during the period, which was higher than RBI’s projection of 20 per cent.

• Mint: The uncanny predictions of ‘Dr Doom’ Marc Faber

Unfortunately, Faber spoilt the effect by going on to predict an apocalypse for the world economy, with hyperinflation, war and religious strife. His final prediction: “A deflationary stabilization crisis will follow in phase four of our road to financial fiasco. Large segments of the population will be totally impoverished. Smart hedge fund managers will all have sold their businesses to banks and will have left the US to live in the Caribbean, Brazil, Singapore, or Thailand, while…Ben Bernanke will flee the US in a hurry.”

Faber on CNBC & Mint - time to go long the Indian indices. A short term trade, mind you!

• Bloomberg: Chicago Merc Customers Citadel, JPMorgan Rebel for Cheap Trades

Rubio’s Breakwater and funds like it rely on the Merc and CBOT for the rapid-fire, low-cost trades that are critical to their success.

Beneath the surface in the conflict between CME and ELX, a bigger battle is brewing. This one is for control of derivatives that aren’t traded on any exchange. The over-the-counter market, run by banks such as Goldman Sachs Group Inc. and JPMorgan, offers swaps and options based on interest rates, currencies and the creditworthiness of corporate borrowers.

The Chicago hedge funds backing ELX are closely associated with the city’s exchanges. The biggest by far is Citadel. Griffin has been featured this year in CME Group advertisements in financial magazines and newspapers, with a quote across the middle of the page that reads: “Risk is what you make of it.”

I imagine that for these huge hedge funds (or more appropriately - market makers), the brokerage costs make the difference between a profitable trading system and an unprofitable one.

• Business Standard: Rs 8,000 crore premium realty projects face delay

. . . the construction cost for large commercial projects was Rs 2,000 per square foot, on average . . . construction cost is growing 20 per cent every year and the developers are carrying a compounded interest burden of 30 to 40 per cent after three years.

By 2008-end, Mumbai and its suburbs will add 15.4 million square feet of office space.

“In Mumbai, developers need to obtain 56 approvals from environment and forest department, pollution control board and others. It takes over a year to get these approvals,”

• Hindu Business Line: Six sectoral indices hit year lows

. . . six key sectoral indices hit their 52-week lows on Monday as the Sensex fell another 2 per cent. The BSE PSU Index , Bankex, Realty, Auto, Power and Capital Goods were the indices that recorded their new 52-week lows on Monday.

. . . defensive sectors such as BSE Health Care and FMCG are trading close to their yearly highs. Market men say that these sectors are not affected much by an increase in interest rates or even the rising crude oil prices.

• DNA: FII unloading spree is worst to date

In May and June, institutions (FIIs +DIIs) have net sold equities worth Rs 11,472 crore. That tops the Rs 9,525 crore net sales by them in January. Despite high cash positions and new fund-offer collections, local institutions have not been shopping hard in the summer sale.

. . . even the long-term fund managers among the FIIs are pruning their India exposures faced with redemption pressures. India dedicated funds saw redemptions of $205 million during the week ending June 18, 2008.

The rupee has been consistently at just below 43, seems to be held back by RBI intervention.

• Barrons: Bye, Bubble? The Price of Oil May Be Peaking

U.S. per-capita oil consumption is 25 barrels annually, while Japan uses 14 barrels per person. China’s 1.3 billion people consume just two barrels each per year, however, and India’s 1.1 billion use less than a barrel a year. In the next decade, oil indeed may hit $200 a barrel.

But prices could fall to $100 a barrel by the end of this year if Saudi Arabia makes good on its pledge to increase production; global demand eases; the Federal Reserve begins lifting short-term interest rates; the dollar rallies, and investors stop pouring money into the oil market.

The SPR, intended as a source of oil for national emergencies, now holds 705 million barrels of crude, equal to about 35 days of domestic consumption. With prices higher, Congress moved in May to stop adding to the SPR as it neared capacity. A sale of 100 million barrels of oil would shock the markets and potentially drive down prices.

• Wall Street Journal: Weather May Ping Natural Gas

LNG imports have been especially low this year because of high demand in Europe and Asia. LNG imports in the U.S. are down more than 70% from last year, according to federal data. “All that LNG that was supposed to come here is more likely to find a higher price in those other markets,”

. . . several LNG projects are set to go online next year — the increased supplies could drive down prices. Mr. Wolff is among those predicting prices will fall next year, possibly below $10 a million BTUs.

• Mint: UK fund firm forecasts $5,000/ounce for gold

“You could easily see for the next several years that prices rise not to $1,000 an ounce, but prices rise to $5,000an ounce or beyond as inflation psychology becomes more and more embedded andpeople become desperate to have a source of value,”

Demand for gold will also rise as central banks become net buyers for the first time in 20 years, driven by developing countries.

The limited amount of gold available, relative to the size of the global capital markets, means a small shift in investments may lead to significant price changes, Wyke said. Total gold above ground is worth about $4.8 trillion, compared with global stock and bond markets worth $135.2 trillion.

Hmm. At Rs 40 per US $, that would translate to gold prices of ~ Rs 70,000 per 10 gms. Unlikely.

• Hindu Business Line: Financial firms cash in on bear market

. . . financial firms are looking to convert this bearish market into an opportunity by focusing on products such as ‘promoter funding’. Promoter funding, a part of the wholesale financing business for these firms, involves offering loans to company promoters who are keen to capitalise on rock-bottom stock prices, to shore up their stakes in companies.

Many new entrants have entered this business, where loans are offered at interest rates between 14 per cent and 18 per cent, with shares or property taken as collateral. “Loan against shares (LAS) is a product offered by most of the banks and NBFCs. Brokerage houses are not allowed by SEBI to indulge themselves into funding activities. We are offering this product from our NBFC . . .

• DNA: Mark-to-market hit awaits banks in Q1

. . . most banks have shifted a major part of their portfolio to held-to-maturity (HTM) in the last two years. These securities are reported at historical costs plus increase in bond prices minus amortisation. Only securities that are under the available-for-sale (AFS) category need to be marked to their current market value.

. . . banks that have a higher share in AFS will take a bigger hit as compared to those with a relatively lower share in AFS . . . banks might try to adjust for the provisions from other reserves.

Watch out for more accounting gimmicks - remember those forex derivatives headaches?

• NY Times: India’s Growth Outstrips Crops

Yet another rouge trader -

• Times Online: Rogue London trader loses $120 million

Morgan Stanley yesterday became the latest financial services group to fall victim to a rogue trader as it admitted that it had suspended a credit trader in London for trying to hide losses of about $120 million (£61.3 million).

The markdown is thought to relate to short-term trading in credit index options that may date back as far as last year. The trades are believed be in CDX indices, complex derivatives used to hedge risk on credit investments such as bonds.

As if they didn’t have enough losses already.

• Business Week: Should You Bet the Farm on Ag Stocks?

The companies that may benefit most from the jump in crop prices are fertilizer makers such as Potash Corp. of Saskatchewan (POT) and Mosaic (MOS), as well as seed producers such as Monsanto (MON).

Monsanto, whose cash flows have risen sharply mostly because of sales of glyphosates, a type of herbicide used to kill weeds that choke crops, will probably start to raise glyphosate prices more sporadically than the once a year it has until now, as raw material costs, tariffs, and tighter competitor discipline permit.

. . . after enormous gains over the past few months, some of these ag stocks may be a little pricey for some investors. At 141.50, Monsanto shares are trading at more than 41 times projected earnings for fiscal 2008, while Potash is valued at 21 times fiscal 2008 estimated earnings.

Two of Amit Wadhwaney’s top five holdings in the $2.0 billion Third Avenue International Value Fund (TAVIX) he manages are companies that have survived droughts and are poised to gain more control of their local wheat markets, from farmers to end-customers.

• Economist: Nasty, brutish and short

“We appreciate that, asshole,” barked Enron’s chief executive, on a public conference call, to a suspected short-seller who had complained about the lack of a published balance sheet. Sometimes bears need even thicker skins. In 1995 Malaysia’s finance ministry reportedly proposed caning as a punishment for abusive shorting.

• Bloomberg: Fed’s Bear Stearns Books Look Prime for Cooking

The Fed doesn’t follow normal accounting rules, as promulgated by any of the major standard-setting boards. Rather, the Fed writes its own, in a document called the Financial Accounting Manual for Federal Reserve Banks. If you ever wanted to design an accounting regime to help a bank cook its books, the Fed’s would be perfect.

If the Fed were a normal bank, it probably would have to put the Delaware special-purpose entity’s assets and liabilities on its own balance sheet, under the Financial Accounting Standards Board’s rules. The reason is that the Fed will bear most of the risk of losses. Under the Fed’s 161-page accounting manual, however, there’s no such requirement. That’s because the manual doesn’t have any rules on the subject.

How nice - make up accounting rules as you go.

• Business Standard: Real estate pushes up PSU bank lending to sensitive sectors

The steeper growth in advances to the sensitive sectors has meant that PSU banks’ share rose to 17 per cent of the total bank credit of Rs 13,76,958 crore at the end of March 2008.

A part of the reason for higher real estate exposure is the classification of big-ticket home loans — upwards of Rs 20 lakh till March 2008 — in this bracket. While private banks have scaled down their retail lending operations, partly due to rising defaults, the public sector players have stepped up the pace.

Central Bank has the highest exposure to capital markets — almost 29 per cent of its net worth — followed by Union Bank (24.77 per cent), Syndicate Bank (20.61 per cent), State Bank of Travancore (20.54 percent), PNB (20.30 per cent) and SBI (18.58 per cent). As per the new RBI norms, the aggregate exposure of a bank to the capital markets should not exceed 40 per cent of its net worth.

With interest rates unlikely to decline, what are expected NPAs for the sub-20 lakh loans? Is this our sub-prime?

• Mint: Insiders say infighting led to BSE resignations

The resignations of the Bombay Stock Exchange (BSE) chairman Shekhar Datta and a director, Jamshed Godrej, is a culmination of intense infighting in the 12-member board of Asia’s oldest exchange.

. . . the board members are clearly divided into two camps and have been fighting on several issues ranging from BSE’s Rs100 crore investment in Calcutta Stock Exchange, a Rs200 crore technology upgrade programme and a 26% stake purchase in Ahmedabad-based National Multi-Commodities Exchange.

. . . there has been deep resentment among some members of the exchange on the lost opportunity of running the corporate debt market in India which was initially awarded solely to BSE by the capital market regulator.

BSE has a miniscule share of F&O trading. And try getting historical EOD data from their website.

• DNA: IT firms brace for Fx losses as Re swings the other way

Kawaljeet Saluja and Rohit Chordia of Kotak Securities expect Wipro to post substantial forex losses because of its huge $3 billion outstanding hedges as on March 31, 2008. They said India’s third-largest IT firm’s accounting for the cash flows and hedge could also wipe out some of the gains from rupee depreciation during the current quarter.

The hedged positions of Infosys and TCS were $760 million and $2.9 billion, respectively. TCS recently reduced the cover by $700 million to $2.2 billion. This is expected to favour India’s largest IT service provider. Infosys had also reduced its forex cover from $1.1 billion in the December quarter to $760 million in March.

• Economic Times: Mkt fall leaves a slew of undervalued stocks

• Via The Kirk Report, Quantitative Finance Review: A Perspective on Quantitative Finance: Models for Beating the Market

This is a perspective on quantitative finance from my point of view, a 45-year effort to build mathematical models for “beating markets”, by which I mean achieving risk-adjusted excess returns.

Where do the ideas come from? Mine come from sitting and thinking, academic journals, general and financial reading, networking, and discussions with other people.

In each of our three examples, the market was inefficient, and the inefficiency or mispricing tended to diminish somewhat, but gradually over many years. Competition tends to drive down returns, so continuous research and development is advisable. In the words of Leroy Satchel Paige, “Don’t look back. Something might be gaining on you”.

You must read Fortune’s Formula to appreciate Ed Thorp’s work.

• Bespoke: Bespoke’s Commodity Snapshot

• World Beta: Sharpe Ratios of Managers

Here is a good PowerPoint that shows some historical Sharpe Ratios for some very successful managers. (It is excerpted from the book Scenarios for Risk Management and Global Investment Strategies ). Ziemba’s point is that managers should not be penalized for upside volatility, only for their losses. So even though Berkshire did almost 25% a year over this time period, it has a lower Sharpe than the S&P500 that returned only 18%. (Great Ziemba PDF here.)

To gain a full understanding of a manager’s performance investors should use alternative metrics to evaluate managers, eg:

Sortino Ratio: uses the volatility of negative asset returns in the denominator (similar to Ziemba’s downside symmetric Sharpe Ratio)
Sterling Ratio: uses the average max drawdown in the denominator
MAR (or Calmar) Ratio: uses max drawdown in the denominator
Ulcer index: Measures the length and severity of drawdowns.

• Mint: FIIs take a different stance

Between 18 March and 31 March, when the large purchases were made, the currency exchange rate hovered around Rs40 to a dollar. Few people expected the rupee to depreciate sharply then. In fact, for even much of April, the exchange rate was around 40 and FIIs took net long positions worth Rs3,834 crore in both the cash and futures segments. The sharp depreciation in the rupee since May, however, seemed to have caused a change in strategy. In May, they were net sellers of Rs9,296 crore in both segments.

Funds tracked by research firm EPFR Global have seen outflows in each of the Asia-Pacific markets in the week till 11 June. On the other hand, these funds saw strong inflows in the late March and early April. Last week’s outflows in Asia ex-Japan funds were the worst since January, while inflows in early April were at a 19-week high.

Very important to understand global money flows. Look for articles for record inflows into ‘emerging market’ funds ~ December 2007 / January 2008 - signs of a top.