Correlation between currency and stocks

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The outlook on rupee is bearish as well. But a turnaround can lead to stock market recovery.

Economies run on confidence. There is no intrinsic value to currency. Instead there is faith that pieces of paper, or electrons representing pieces of paper, can be exchanged for tangible goods and services.

Even the worth of that intrinsically valueless paper is stretched by sleight of hand. Banks and financial institutions routinely dole out multiples of the money they possess. Insurers do the same thing with premiums. If at any given time, a large number of depositors want their money back, or there is a rush of insurance claims, the system would collapse.

The confidence trick of fiat currency multiplied in effect by fractional banking is the foundation for growth. It works fine so long as people believe in it. When faith collapses, as in Zimbabwe, the worst case scenario is a reversion to the barter system.

In less drastic situations, assets flow out of shaky currencies to “harder” currencies. Brazil and Argentina have creatively used this to deal with hyper-inflation. At various times, both tied local money supply to respective forex holdings.

In the last three years, the world has realised there is no such thing as an “absolutely hard” currency - one in which everyone has faith. The US dollar performed that role for over 60 years. But the American economy has been so badly shaken by the subprime bubble that the USD is no longer considered a reliable reserve currency.

The Euro cannot be a substitute; the national finances of Greece, Ireland and Portugal, are dodgy. Japan has been in recession for two decades, ruling out the Yen. Switzerland, Singapore, and so on, are too small to issue the quantity of paper required. The Yuan cannot be freely traded, even assuming everybody has faith in the People Republic of China.

Hence, there are musical chairs across global financial markets. Capital has moved into every economy and every sector with signs of stability and out-performance. It has moved out again, at the first signs of trouble.

India was a beneficiary of the musical chairs in 2009 and 2010 when lots of overseas investment flowed into rupee assets. The Indian stockmarket was among the best performers then. Now, we’re seeing the flip side as foreign investments flee.

Unfortunately, Indian investors cannot follow the FIIs out - the rupee isn’t fully convertible. However, Indians can track major currencies and bet on them through simple exchange-traded, rupee-denominated derivatives like currency futures and options. The huge volumes this segment has developed on NSE and MCX are ample testimony to the need they service.

One good thing is that there is never a bear market in currencies. When one currency declines in relative value, another must rise. Leverage is also excellent at an average margin of about 2 per cent of contract value.

Another good thing is that nobody has full control over the rupee’s direction. India's financial planners are struggling with the “impossible trinity”. It's not possible to allow capital flows, manage local money supply and fix the exchange-rates simultaneously.

Over the next year or so, there could be a clear bearish trend towards the rupee for the same reasons that there is a bearish tilt to Indian equity. One bearish factor is inflation. Another is shady national finances and the danger of a bloated fiscal deficit. A third is potential political risk and associated policy risks. A fourth is that FIIs have simply decided to go under-weight on the rupee.

All the above have negative impacts on the rupee and hence, the rupee should lose ground against most major currencies. A bearish stance on the rupee seems a reasonable way to hedge an Indian equity portfolio since the rupee seems correlated to Indian equity indices at this instant.

However, whatever the fundamental stance, any currency trader must watch technical trading factors. You can rollover winning currency futures positions but you must keep strict stop losses and apply them to losing ones. A crisis somewhere far away can have huge repercussions.

There is no way for an individual to track all the relevant fundamentals. There is also little reason to try. All Indian exchange-traded contracts are rupee-denominated. A trader can focus on the Indian economy if he wants to watch fundamentals.

It's probably more practical to use purely technical trend-following methods. Currency trends tend to be well defined and last reasonable lengths. Moving average systems with 2-3 three month periods (40-60 days) seem to give excellent returns. Snapbacks in the rupee coincide roughly with stock market recoveries. If the rupee's moves are somewhat more predictable, why not head there?