Indexology^® Blog

The S&P GSCI Crude Oil Total Return is up 15.2%, its biggest six day gain, ending Aug. 18, 2016, since the six day gain of 16.1%, ending on Apr. 13, 2016.  As both the IMF (International Monetary Fund) and IEA (International Energy Agency) consider the oil price as a major input to global GDP estimates, and the IMF states the oil price assumptions used for the current World Economic Oulook Update (WEO) are about $10 higher for 2016 and 2017 than those used for the April 2016 WEO, one may consider evaluating the impact of an oil price increase on equity sectors since equities are the biggest holding for many investors.

Using monthly index data from Dec. 1998 for S&P 500 Sectors and oil, and also data from Aug. 2006 for S&P 500 Bond Sectors, some conclusions can be drawn about the sector sensitivity to oil and sentiment in sectors.

Interestingly, but perhaps not surprisingly, when oil rises, it helps all equity sectors except Telecom.  In the table below, for every 1% increase in oil, the telecom sector loses 2 tenths basis points. It’s not much but it is the only losing sector.

Telecom may suffer with rising oil prices since gasoline and automobile demand may decrease that slows integration of connectivity in cars. It also may slow growth in digital technologies that make it easier to access and pay for public services using mobile devices, such as parking and transportation.  Also, investors are feeling most pessimistic about telecom since Dec. 2014, based on the excess return of bonds over stocks in the sector.  Back then, the index lost 10.8% through Sep. 2015, so it is possible this could indicate another drop.

Putting aside energy and materials that clearly rise from an oil increase, technology gains most from an oil increase, rising on average nearly 22 basis points for every 1% gain in oil. Energy companies have increased efficiency tremendously over the past few years by investing in new technology, so as oil rises, it makes sense that energy boosts the tech sector. However, while investors are still willing to take some risk in the upside of the tech sector right now, the pessimism in tech (rapidly declining risk premium) has peaked this month the most of any sector, reflecting a shift away from the sector, despite the oil gain, and that is a warning signal.

One must consider the fear in tech for the broader implications on the stock market, given technology is the digital backbone of the economy and the mood is getting gloomy. This is since tech is one of the most highly correlated (0.83) sectors to the S&P 500 and the S&P 500 captures much (52%) of tech’s losses.

The falling dollar may help oil further if the fed doesn’t raise rates. It gains about 4.3% for every 1% US dollar drop that should translate into almost at 1% gain for tech. However in the past week the dollar fell near 1.5%  but tech has only gained about 25 basis points in this oil rally of more than 15%, which reflects potential economic weakness.

More than a 5% discount in S&P 500 bond over stock performance and some persistence historically indicates a true downturn in the overall stock market. There have only been 3 consecutive discounts one time since 2011 and that was in Q1 2016. Now there is still a slight premium but it is dropping quickly, so it doesn’t feel like a crisis but it’s jittery.

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VIX has spent the whole of August below 14, and remains – at time of writing – close to its lowest levels in two years.  But the present calm may be dependent on a short-term seasonal effect; and we are approaching the traditional period where it ends.

August is traditionally a quiet month for U.S. equities.  The usual deluge of corporate announcements, elections, and product launches attenuates to a trickle, while traders and investors decamp to their holiday destinations.  Then, in September and throughout October, the world returns to business, sometimes only then announcing or processing events that may have occurred over the summer.

The lack of news flow in August and subsequent ramp-up creates a seasonal effect in volatility, with VIX depressed over the summer months and rising through late August and early September.

The graph below shows the historical extent of such seasonality, plotting the average level of VIX in comparison to its one year trailing average at each point in the year.  The effect is not dominated by one or two outlier events, but instead appears persistent; the grey shaded area shows a similar pattern for the 25% and 75% percentile range of values.  Today’s value is well below the historical interquartile range as VIX is 30% below its average level for the past year.

Interestingly, there is a clear seasonal lull between late June and early August, and a significant increase towards the end of August.  The 35^th week of the year showed, on average, the biggest rise in volatility.  Given that we are presently approaching the end of the 34^th week of 2016, investors might wish to bear this history in mind.

In my blog “Introducing the CBLO Rate,” we discussed what the collateralized borrowing and lending obligations (CBLO) rate is and how the S&P BSE Liquid Rate Index would be useful for market participants.  In this post, let’s discuss the history of the CBLO rate and nature of CBLO rate movement.

The repo rate is the rate at which banks borrow from the Reserve Bank of India (RBI), and the reverse repo rate is the rate at which banks deposit their excess cash with the RBI; both are policy rates that move only when the RBI decides to change them during its periodic monetary policy review.  On the other hand, the CBLO rate is completely market driven and changes depending on the short-term liquidity situation in the market.

Generally, the CBLO rate should range between the repo and reverse repo rates, otherwise it would create an arbitrage opportunity for banks, which are active in both markets (repo and CBLO).  If the CBLO rate were to move out of the band of repo and reverse repo rates, banks could borrow from the cheaper market and lend in the more expensive market.  For example, if the CBLO rate is hovering around 5%, which is lower than the reverse repo rate of 6%, banks could  profit by borrowing at the CBLO rate and lending at the reverse repo rate (or depositing the same amount with the RBI), earning a risk-free profit of 1%.

Exhibit 1 illustrates the 30-day moving average CBLO rate, repo rate, and reverse repo rate.  The 30-day moving average is used to avoid outlier numbers and get a meaningful picture of all three rates.  From 2004 through the first half of 2009, it appears that the CBLO rate was more volatile and frequently outside of the repo rate and reverse repo rate band.  However, since 2010, the CBLO rate tended to be in between the repo rate and reverse repo rate, except during the second half of 2013 and first half of 2014.   Starting in November 2009, the RBI asked banks to set aside 5% of funds borrowed under the CBLO as a cash reserve ratio in order to stop discourage arbitrage opportunities between the two markets.

Exhibit 1: 30-Day Moving Average 

While the CBLO market is gaining popularity among various money market instruments, at present it is only accessible to institutions such as banks, financial institutions, corporates, etc., and it is yet to become available for smaller investors.  Another problem with the CBLO is that the treasury manager has to roll over deposits every day unless he finds a borrower or a lender for the desired maturity in the CBLO market.  It is worth reiterating that the majority of liquidity is in overnight tenor, which means other tenor rates may have a liquidity premium as well.

One possible solution for this could be an ETF based on the S&P BSE Liquid Rate Index, an index that seeks to track the weighted-average CBLO rate.  An ETF fund manager would roll over the deposits each day to earn the daily overnight CBLO rate.  This would also open the CBLO up to smaller investors as they buy ETFs to get exposure in the CBLO market.  This could effectively help increase liquidity in the CBLO market further.

While we have a liquid overnight CBLO market, it will be interesting to see how the term segment of the CBLO market evolves in the future.

On Aug. 4, 2016, the Bank of England cut its benchmark rate by 25 bps to a low of 0.25%.  This move, coupled with its announcement of a GBP 70 billion expansion of quantitative easing, with GBP 10 billion committed for the purchase of investment-grade corporate bonds, is furthering the positive performance of these asset classes.  Quantitative easing is an asset-buying program that is meant to keep rates low to stimulate the economy.

The S&P U.K. Gilt Bond Index had returned 16.93% YTD as of Aug. 10, 2016, while the S&P U.K. Investment Grade Corporate Bond Index came in at 17.32%.  Both of these asset classes continue to rally.  Since the vote for the Brexit on June 23, 2016, a rally based on flight to quality was largely expected for the U.K. gilt market, but the U.K. investment-grade corporate bond market has also has seen significant tightening of yields, despite concerns that a Brexit would negatively affect U.K. corporations.  Since the Brexit vote, the S&P U.K. Gilt Bond Index has tightened 75 bps and the S&P U.K. Investment Grade Corporate Bond Index has tightened 105 bps.

The question remains as to how much lower yields can go and how the Brexit will actually unfold.  Brexit impacts on the U.K. economy are starting to come in, with U.K. manufacturing output for Q2 2016 reversing its positive momentum and experiencing a sharp decline.

Bankers and corporate treasury managers may be facing the challenge of parking excess cash for a short period, maybe overnight, to earn some income or interest without compromising the security of the funds.  Similarly, there are many banks and corporates that need cash in the short term at the lowest possible rate.  While there are many possibilities (the call money market or repo market, commercial paper, etc.) each comes with certain advantages and disadvantages.  In India, various banks, financial institutions, and corporates are increasingly using the collateralized borrowing and lending obligation (CBLO) rate to lend or borrow money, for periods ranging from overnight up to one year (although the majority of trades are overnight).

What Is the CBLO Rate?

Unique to India, the CBLO rate facilitates the borrowing and lending of funds with G-sec as collateral.  It is also considered secure, as Clearing Corporation of India Ltd. (CCIL) is the central counterparty to all trades and guarantees settlement of CBLO trades.  Also, all trades are executed through electronic order book and are anonymous.  One of the distinguishing factors of CBLO is “tradability,” which means it allows the lender or borrower to reverse the position.  For example, in the case of a borrower, he can repay a loan before the expiry of the term.  It is no small wonder that CBLO has evolved as one of the most liquid money market instruments in India.

Currently, the collateralized market, CBLO, has become highly liquid and is dominating the short-term market in terms of volume of transactions.  Over the last eight years, the trading volume of CBLO segment has become higher than the combined trading volume of overnight call and market repo markets.  Exhibit 1 gives the historical trading volume of the short-term market in India.

Source: Reserve Bank of India (www.rbi.org.in).  Data in INR billions.  Data as of July 31, 2016. Volume data is from Jan. 1, 2008, to July 31, 2016.

As CBLO is gaining popularity among banks, financial institutions, and corporates, it is difficult to know the returns generated by lenders by daily rolling of deposits in the CBLO market due to the lack of a transparent and rules-based benchmark.  With the launch of S&P BSE Liquid Rate Index, which is designed to measure the returns from a daily rolling deposit at the weighted average CBLO rates, we try to bridge this gap.  The index is calculated using the weighted average CBLO rate for transactions maturing on the following business day and with a settlement type T+0.

From Dec. 31, 2015 to July 31, 2016, the weighted average CBLO rate ranged from a low of 5.16% to a high of 7.36%.  However, the S&P BSE Liquid Rate Index had an annualized average return of 6.67% during the same period.