Thread by @kirtan0810

Liquidity is fueling the stock market rally says everyone. What is this liquidity? How does it get created? How does it fuel stocks, commodities? (Thread)

Hit the ‘re-tweet’ and help us educate more investors’ (1/n)

Lets start with basic, y does inflation increase?
Most feel bcoz of higher demand & lower supply but that’s nt the only factor. Imagine there is a shortage of laptops wrt the demand, but there is no liquidity in the market (people don’t have monies) will the price of laptop⬆️? No

So, Inflation takes place because the demand supply situation is accompanied by liquidity, people have the monies to spend and hence the price goes up. Inflation does not take place only because of the demand supply gap (3/n)

What role does RBI play?

Its RBI’s job to keep inflation under check. RBI is comfortable keeping Inflation between 2-6% currently. So if Inflation is increasing, how can RBI control it? Can RBI do anything to demand & supply? Nothing (4/n)

So the only tool available with RBI to control inflation is controlling liquidity. If RBI is able to reduce liquidity in the market, less money will chase the goods and hence Inflation can be expected to stabilise. (5/n)

What does RBI do?

As liquidity is provided to the market by banks, RBI tries controlling banks by increasing interest rates (Repo Rate). It expects that if Repo Rate goes up, the spiralling effect will reduce liquidity in the market. (6/n)

How?

Repo rate is the rate @ which banks borrow 4m RBI. If Repo ⬆️, the cost at which banks borrow is expected to ⬆️. Also the MCLR/Base rate 4 banks includes the repo rate 4 calculation & hence it is expected that if Repo ⬆️, banks will ⬆️ their lending rates. (7/n)

So, if inflation goes up, efforts are made to increase interest rates by which expectation is that individuals will take lesser loans and hence demand for products will reduce and hence inflation will stabilise. (8/n)

The reverse is also true, when inflation falls, interest rates are reduced so that the loan becomes cheaper and more loans are borrowed and hence demand for products will increase and hence inflation can increase over a period of time. This is the current situation (9/n)

So what happens when there is any economical problem? 1987, 2001, 2008, 2020?

Suddenly demand for products fall, business reduces and that leads to job loss (10/n)

What does the government/central banks do?

Reduce interest rates to entice individuals, corporates to borrow so that there is atleast some demand maintained. All economic crises, central banks have reduced interest rates. In 2008 some 4% repo rate was reduced (11/n)

What’s happening right now?

In the fear of crises, all global economies (specifically US) are doing the following,
a. Stimulus – Giving more monies in the hand of ‘individuals’ through various schemes like unemployment benefits etc. (12/n)

b. Interest rates – Keeping it close to 0 so u can borrow more & ⬆️ demand. ‘Corporates’ have cheap loans available now
c. Bond buying program – US is buying $120B of bonds each month & giving cash to the market, specifically the ‘Financial Institutions’ who r selling the bonds.

Now, individuals, corporates & financial institutions, all have monies, what will they do with it?

a. Interest rates in their country is close to 0 so they won’t invest in debt as there r no returns 2b made. All that liquidity is invested in equity & commodities (14/n)

b. The choice of Equity investment is domestic (US) or Emerging Markets (EM).Why would they choose to invest in EMs? (15/n)

Why does the liquidity flow to EMs?

The answer is $.

Lower $ propels this EM trade (16/n)

Before we move to understanding how does the lower $ propel EM trade, lets understand y does the $ fall in the first place?

If the fed is continuously printing $ & supply it 2 the market, the supply of $ is high & hence $ falls. More the $ printed, less the value. (17/n)

Lower $ is positive for EMs, why? 1$ from 75 becoming 1$ = 70, how does this help?

a. EM companies who have taken loans in $ will have to pay less rupees (from 75 earlier to 70) for every $ loan taken and hence increase in profitability. (18/n)

b. Imagine FII’s investing when $1=75. So they convert 1$ to 75 rupees & invest the 75 rupees. Lets assume the 75 investment becomes 82.5 a 10% profit. While taking the investment back, FII’s will convert 82.5 into $. If $ falls to $1=70, they will receive $1.18 (19/n)

$1 invested and $1.18 receives is an 18% return on investment in $ where as in rupees the return was 10%. Which is why a falling $ is a boon for FIIs (20/n)

But wouldn’t $ falling & Rupee rising make Indian exports uncompetitive? For every $ in export u were making 75 which will become 70

RBI 2 avoid the situation is on a $ buying spree which is leading 2 creating liquidity locally. (21/n)

The more the $ RBI buys, the more support $ gets from falling against the Rupee. RBI has bought $97B since April! So when RBI buys $97B it gives to the market close to 6L cr of rupee liquidity and that’s RBIs liquidity infusion in the system. (22/n)

RBI has also bought some bonds from the market to infuse liquidity but that’s a small number. In Oct-Nov the data was,
40,000 cr OMO bonds
20,000 cr OMO SDLs
30,000 cr Operations twist (23/n)

Liquidity has pumped rates very low in India
a. Overnight rates between 2 banks is 1.15% lower than repo
b. 3 months Tbills are trading at 0.90% below the repo
c. CP’s & CD’s trading below repo
Where as Repo was designed to be a rate above which the other rates will be. (24/n)

This global as well as local liquidity is driving the stocks & commodities market
a. Crude is ⬆️ 40% 4m October lows
b. Copper @ 6 years high
c. Aluminium 3 years high
d. Nickel 17 months high
e. Wheat 6 years high
f. Rubber 4 years high
e. Soybean 6 years high (25/n)

Some other observations,

a. 2020 has seen 6 times more liquidity than 2008

b. Every 1 point drop in $ index is worth at least $3B in FII inflows. $ index from its peak of 103 in march is at below 90 right now. (26/27)

This rally is not stopping till $ starts moving up!

There are many such interesting threads pinned to my profile, do give it a read. Happy Learning. (END)