It's Tough to End Easy Money

Asad Dossani

In December 2016, the US Federal Reserve raised interest rates. It was the first increase in a year, and they signaled at least three more in 2017. So far, they have lived up to their promises. They've already raised rates twice this year, in March and in June. They have also pledged to reduce the size of their balance sheet, i.e. wind down their infamous quantitative easing.

This has come as a surprise. For many analysts, myself included, the chances of the Fed keeping its word seemed low. In December 2015, the Fed raised rates for the first time in seven years. They promised three more increases in 2016. But rates were raised only once last year.

After their June meeting, a rate hike by year end seemed very likely. At the time, the Federal Funds futures implied a 61% probability of another rate hike by December. But that has changed considerably. As of the end of July, this number is down to 43%. That's a large drop in just one month. The market believes its more likely the Fed won't raise rates again this year.

Many reasons are put forward for this. US inflation is lower than expected. Economic conditions are good, but could be better. The political situation remains tenuous. Later this year, the US congress will have to raise the debt ceiling. While a crisis on this front seems unlikely, it can't be ruled out.

But there's a bigger underlying reason. For the Fed and other central banks, it's tough to end easy money. Very tough. You'll read plenty of reasons why rates should go down or stay the same. You won't read much arguing for rate increases. And this is because rate increases create short-term pain, in exchange for long-term gain.

In the short term, markets will fall. Volatility will go up. Economic activity may slow down too. But the most important long-term benefit is never mentioned. And this is the incentive to save more and borrow less. Higher interest rates encourage people to spend and invest out of their savings, rather than by borrowing. And this is extremely important for long-term economic prosperity.

But to get there, we must endure short-term pain. Imagine taking drugs away from an addict. This is tough to do. This is what we are up against in today's economy.

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Market Notes

Is the Rollover Data Indicating a Correction?

The Nifty 50 Index ended the July series strong at a new life high above the 10,000 landmark figure.

Last time, in our June expiry rollover report, we saw higher-than-average rolls but open interest (OI) in absolute terms remained flat and the Nifty also remained unchanged for the expiry. So the rollover data gave us no clear indication. But the put call data seemed quite encouraging. The 9,400 put had solid OI outstanding, so we weren't expecting the index to slip below the 9,400 level. The index hit a low of 9,449 on the first day of the July expiry and never turned back. It rallied straight to trade above 10,000 towards the end of the expiry.

So will the index continue with its momentum in the August series as well? Let's see what the rollover data suggest this expiry.

But first, what is rollover?

Rollover refers to traders shifting their future contracts positions from the near-month contract to the next-month contract. For example, Nifty traders are shifting their future contract positions from the July expiry to the August expiry. Here's the formula:

Rollover % = Next Month OI (M2)
--------------------------------------------
Near Month (M1) + Next Month OI (M2)

The rollover formula tells the percentage of contacts rolling into the August expiry from the total contracts outstanding from the July and August expiry.

This month, Nifty rollovers stood at 67%, which is lower than the previous three-month average of 70%. Open interest (OI) was 1.72 crore contracts compared to 2.03 crore in the previous expiry. Open interest in absolute terms decreased and the rolls were also on the lower side. This is a bit discouraging.

The Nifty gained 5.4% for the expiry with absolute open interest decreasing and lower than average rollovers. This indicates most of the long positions in the index that were built up in the July expiry did not roll into the August series.

Apart from this, the absolute OI outstanding at the end of expiry is now at its six-month low. So apart from longs not rolling into the August series, we have also seen some OI disappearing by the end of the July expiry.

Nifty Options Matrix (Open Interest)

Nifty Options Matrix (Open Interest)

On the options front, the Nifty put-call ratio (PCR) stood at 1.26. This means put open interest is higher than call open interest. Being a contrarian indicator, a high PCR reading is generally favourable for the markets.

The 10,000 strike call has highest built-up with 30.12 lakh OI. And 9,800 strike put has highest built-up with 38.36 lakh OI. Based on this, 10,000 can act as resistance and 9,800 as support in the August expiry. As seen in the chart above, the 10,000 put too has strong OI outstanding. Thus we can expect a tug of war around 10,000.

Now let's look at the Nifty chart.

The index traded on a strong note during the expiry. It opened gap down on the first day of the expiry and hit a low of 9,449. But the selling was temporary as the index recovered later that day and went on to hit a fresh life high in the second week of the expiry. The bulls did not stop and the index kept hitting new life highs to achieve the landmark figure of 10,000 in the last week of the expiry. Finally, it ended the expiry up 5.4%.

The index is currently trading near its channel resistance line at 10,000. This indicates limited upside in the index. The RSI indicator is also trading in extreme overbought territory. So a correction towards the channel support line near 9,800 cannot be ruled out.

Nifty 50 Index Ends July Expiry Above 10,000
Nifty 50 Index Ends July Expiry Above 10,000h

The Nifty index rallied strongly for the July expiry but the rolls were on the lower side and the absolute OI was also low (at its six-month low). This possibly means that the bulls are gradually exiting their position which might weigh on the index.

Technically also the index is overheated and near its resistance of 10,000.

But the put call ratio is still strong. And the 10,000 level has the maximum OI outstanding in both call as well as put. So the 10,000 level might act as a deciding level for the August expiry. Sustained trading on either side of this level might suggest further direction for the index.

From The Market Wizards...

'The sole objective of trading is not to prove you're right, but to hear the cash register ring.' - Martin Schwartz

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