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Attack on America Scuttles Bond Bulls

Do not let fear dictate investment decisions

The attack on America decisively punctured the bull-run. Bond market turned volatile with added uncertainty dragging bond prices. This week, gilt funds have lost an average 0.64 per cent while the more conservative medium-term bond funds have shed around 0.23 per cent. With spectre of a US counter-attack looming large and rupee on a free fall, investors are beginning to take refuge in the "safe" haven of cash funds. The rupee hit a new lifetime low of 47.83 on Friday under panic demand for the greenback. In the last fortnight, the Indian currency has lost nearly 1.45 per cent. Foreign institutional investors have been net sellers in the current month, offloading equities worth Rs 223 crore in just 10 trading sessions.

"There is a strong undercurrent of unpredictability in the markets and yields have moved up. The current scenario has more downside than upside though the market expects RBI to step in to stabilise the rupee," says Dhawal Dalal, bond fund manager at DSP Merrill Lynch.

We outline the all pervasive concerns guiding the market sentiment. However, these factors are hypothetical and may not eventually unfold to shake the markets.
1. The near certain retaliation by United States is the biggest worry now. The magnitude and the spread of the attack hold key to its ramifications on the financial landscape. While the action could be localised, prolonged resistance/counter alliances could heighten the pitch of conflagration.
2. A strong retaliation by the US could have a lasting impact on the oil prices. A double whammy, this could pull down the rupee as oil forms nearly 30 per cent of the total imports. Further, spiraling oil prices are bound to damage any chances of an economic recovery.
3. The current fall in the rupee is partly attributed to foreign funds raising cash levels to meet repurchase demand. With US markets expected to open on Monday, market men fear that US investors in emerging market funds are likely to press the sell button.
4. If the current run on the rupee turns into a speculative attack, the RBI could be forced to raise short-term interest rates as happened in July last year. This is bound to sharply erode bond prices.
5. Last but not least, the current round of uncertainty has only catalysed an expected fall in bond prices. The poor spreads between overnight call rates and the 1 to 5 years gilt segment had made this segment vulnerable to a correction. "It's a piquant situation where there have been sharp losses at the short-end. Thus, you cannot cut maturity profile. On the other hand, there is high uncertainty if one invests beyond five years. Clearly, cash is the best bet,'' quips a fund manager.

While there are threats galore, Monday morning could throw up some positive surprises.
1. While the market is yet to see any intervention from the RBI, the central bank is now widely expected to step in to stabilise the currency. The reserves are extremely buoyant at over $45 billion. Thus, any intervention will also soothe nerves in the bond markets. Further, inward dollar remittances have been bottled for the time being in New York. Once the banks open there, these dollars will get remitted to India creating fresh supply.
2. With nearly a week between the bombing of WTC and opening of US markets, investors are expected to behave in a more sensible manner. Thus, if fears of redemption blow over, a relief rally could be on the cards.
3. In such times, Central Banks provide more liquidity into the system to tide over the crises to bring back consumer and business confidence and stave off any recessionary pressures. While the domestic markets are flush with liquidity, RBI would also pump more money if required. It has also reiterated its bias for softer interest rates. Given the fresh bout of unpredictability, bank deposits are only going to go up while demand for credit remains weak.
4. With a sharp reversal in bond prices, bond yields have again become attractive. With the underlying liquidity strong, both bond markets and debt fund NAVs could see a sharp recovery once the sentiment stabilises.

Options for Investors
Negatives outweigh positives driving panic selling in the markets. While it's impossible to predict what will happen, it is important not to sell indiscriminately and reshuffle your portfolio in an attempt to time the market. Selling at current levels means you only convert notional losses into real ones. Financial markets were pretty resilient in 1999 even during the Kargil war. And this time, India is no where in picture except in its support to the US. Thus, do not let fear outweigh rationality and dictate investment decisions. After all, fear is just as poor a motivation for financial decisions as greed!