MARKET PULSE: 21 JUNE 2012

MARKET PULSE: 21 June 2012

RBI struck between stake holders’ expectations and Governments’ policy inaction

It is the first time the market has seen such a strong defence of monetary actions by the Governor. At the outset, RBI is indeed not in an enviable position during these crisis days to deliver expectations from the stake holders without minimum support from the Government. It becomes worse when the external sector turns excessively adverse exerting strong headwinds diluting the impact of monetary actions. This time, Industry and financial markets expected 50 bps CRR cut based on spike in drawdown from LAF counter to over Rs.1.25 Trillion on run into policy day. This was seen to be extremely high as against RBI’s tolerance level of 1% of NDTL (around Rs.60K Crores). There was also precedence of delivering 75 bps CRR cut ahead of policy day when drawdown from LAF counter exceeded Rs.1.5 Trillion. Although RBI prefers OMO for liquidity injection, it is liquidity neutral to cover week-on-week bond supplies from RBI. The major beneficiary of OMOs is the Government, to keep cost of borrowing at administered affordable rate. The expectation of 50 bps CRR cut obviously did not have linkage to any economic data. Moreover, current CRR of 4.75% is seen to be at higher end of 3.0-6.0% band with room for downward revision. The industry also expected 25-50 bps rate cut based on downtrend in core inflation print below 5%, weak IIP data of near zero percent growth and shocker from Q4FY12 GDP growth of 5.3%, and considered downside risks to growth is more severe than upside risks to inflation. This being the base numbers for FY13, it is seen as impossible for the Government to achieve the set ambitious targets for FY13. It is also seen that MM Sovereign yield curve is inefficient with 1Y yield below 10Y yield, thus not building the time value, with the need to build steepness in the curve by guiding the 1Y yield down. There are no signals to look for sharp reversal in interest rates to validate the inversion in the yield curve. There is no significant impact on MM rate curve since delivery of 50 bps rate cut in April because of elevated overnight rate at higher end of LAF corridor. It also looks difficult at this stage to shift system liquidity from deficit to surplus to get the benefit from shift of operative policy rate from Repo to Reverse Repo rate. The combination of these factors built strong expectation of 25-50 bps rate cut by the Industry and entire financial market participants. Moreover, current operative policy rate at 8% is seen to be trading at higher end of 4.0-9.0% acceptable band with good room for downward revision. Therefore, it is fair to conclude that the expectation from the Industry and financial market participants was genuine, thus the post-policy disappointment!   

What went wrong? The issue is between the Government and the RBI. It is true that RBI cannot shift into dovish monetary policy stance when headline inflation is at elevated levels. There seems to be no resolutions to many critical factors. The common man is concerned about high food price inflation. While this cannot be controlled from demand side, there is little action from the Government to address from supply side and through administrative efficiency. It is less said the better on fuel price inflation as it stays administered with high subsidy content. The food and fuel price inflation print will move up on roll-out of minimum support price on agriculture commodities and price hike in diesel, kerosene and cooking gas. The other major concerns of RBI which have direct relevance to monetary system are from fiscal deficit and Balance of Payment. The impact of these is felt on rupee liquidity, flight of rupee capital, exchange rate instability and upward pressure on interest rates. It is impossible for RBI to control inflation with high fiscal deficit and weak rupee. RBI wants to see tangible actions in pass-through of subsidy cost; measures to bridge Current Account deficit and reforms to attract sustainable long term flows into Capital account. It is believed that unless these structural issues are resolved, shift into dovish monetary stance may not be effective to support growth.

What next? The resolution to this growth-inflation conflict obviously is in the hands of the Government. It will be a long-drawn process but the first step needs to be taken quickly with political consensus. It is not that the Government is not aware of these critical needs; the issue is in its execution capability (and/or limitation) to bring the coalition partners together. There is no guarantee that parties outside UPA will extend support to Government on these agenda. The fragmented political mandate is seen as the curse for the Indian economy; Government is unable to bite the bullet on fear of opposition from other political parties or has deep pockets to absorb costs. It is crisis time and it is essential for the Congress Party to manage support within and outside UPA to roll-out next generation reforms to attract off-shore liquidity and capital and get into the act of fiscal consolidation. The economy runs the risk of sovereign rating downgrade to junk status by global rating agencies. We may not accept it but lenders and investors will take note of it and move away from the storm. It will be catastrophic on asset markets; weak rupee, high bond yields and weak equity market will kill the investor confidence on the Indian economy. The concerns from the rating agencies are on political governance, fiscal consolidation, growth, inflation, balance of payment, exchange rate stability and so on. The Governor can rest assured that the Industry and financial markets will be with RBI to exert “pressure” on the Government to get their acts right to get the economy back on track.      

What is the take-away? It is possible that RBI will be into an extended pause mode. The headline inflation (wholesale and retail) will stay high and inflation adjusted borrowing cost will be low, not considered as major risk to growth. There will be added pressure from external sector as FED/ECB/BOE starts roll-out of next round of stimulus measures, seen as inflationary for India. There is lot to do for the new FM to bridge gap between expectations from RBI and execution capabilities of the UPA. The other stake holders of the economy have no option but to wait and hope for the best!

Currency market

Rupee traded 55.82-56.16 within immediate support at 56.18 and resistance at 55.75 before close at 56.15. The unfortunate part is that post-policy bearishness on rupee could not take the benefit of sharp rally in EUR/USD into 1.2750. What next? FED delivered to expectations; provided guidance to maintain policy rate at near zero level till 2014 and extended Operation Twist into rest of 2012. This can be considered as neutral for the USD and USD Index is expected to stay within 80.50-82.50 range. No QE3 is a disappointment but most participants expected this liquidity injection in the last quarter of 2012. Let us continue to stay tuned to the set near term range of 55.75-56.50 with extension limited to 55.50-57.15. The extended weakness into 56.90-57.15 will attract good supplies from the market. Spot rupee around 57 will be too stretched, hence considered good to sell 12M receivables (at value above 60) and shift 3-10 years rupee liabilities to USD. For now, let us watch 55.85-56.50 with bias into higher end. The strategy for exporters is to sell 3M/September dollars above 57.50 (spot around 56.50); 6M/December dollars above 58.50 (spot around 56.75) and 12M dollars above 60 (spot around 57).

EUR/USD traded end-to-end between sell zone at 1.2725-1.2750 and buy zone at 1.2575-1.2550 (high of 1.2743 and low of 1.2567) and into consolidation mode at 1.2650-1.2750 post FOMC. There is no big-bang from the FED but has delivered to expectations to provide post-FOMC price stability. Now, the focus is into the Euro zone. We retain the near/short term bullish outlook on the dollar and would allow bit of consolidation till dust settles down. For now, let us watch consolidation at 1.2550-1.2825 with test/break either-way to attract. The strategy is to trade end-to-end of this move by selling at 1.2775-1.2825 (with stop above 1.2850) and buying at 1.2575-1.2525 (with stop below 1.2500).

USD/JPY rallied from immediate support above 78.75 but could not take out resistance at 79.75 (low of 78.77 and high of 79.67) and runs the risk of extension into 80.25-80.50 before down. The short term trend below 78.75 into 77.75 ahead of 76.00-75.50 is valid. For now, let us watch consolidation at 78.75-80.25 with test/break either-way to attract. The strategy is to stay short at higher end with tight affordable stop for test/break of lower end into set objectives. In the meanwhile, EUR/JPY has reversed sharply from above 99 to take out 101. Here again, the short term trend is for test/break of 98.50 into 95.75. We need to look for right level to sell to set up a 500 pip trade. Watch this space in the twitter for the sell inititation.

Interest rate market

Bond market erased post-policy losses supported by OMO announcement to push the 10Y Bond yield to lower end of set near term ranges of 8.10-8.35% (new) and 8.35-8.60% (old) before close at 8.12% and 8.39% respectively. The LAF draw down is over Rs.1 Trillion and there will be more OMOs (probably every week or alternate week) to guide stability at the lower end of set ranges. The first signal of move into the higher end will be on cut in LAF draw down to below Rs.75K Crores. For now, watch 10Y (8.15% 2022) Bond yield at 8.10-8.20% and 8.79% 2021 at 8.35-8.50%. There will be buying interest in 8.79% 2021 on demand from RBI at its OMO counter; this would be a traders’ delight bond.

OIS rates stayed firm finding good support above the lower end of set ranges of 7.75-7.95% (1Y) and 7.25-7.45% (5Y) before close at 7.85% and 7.30% respectively. No change in view and the strategy is to stay paid at 7.80-7.75% (1Y) and 7.30-7.25% (5Y) for move into higher end in due course.

It was perfect move in FX premium, to ride the 3M from 6.25 to 7.25% and 12M from 4.75 to 5.75% and now closed at 7.2% and 5.7% respectively. What next? There is no sign of reversal despite this sharp move. The interest rate play is strongly in favour of up move while exchange rate play is neutral. The risk is of shift in exchange rate play on spot rupee reversal from 56.50-57.15 which could drive the premium sharply up. For now, let us watch 6.75-7.5% in 3M and 5.5-6.0% in 12M. The strategy is to stay “paid” for higher end. Let us pay 12M at 5.60-5.50% for 5.95-6.0%. It would be good for spot rupee if premium can stabilise at elevated levels.

Equity market

NIFTY got solid support from bullish cues from western bourses but weak domestic cues prevented an extended run, thus stalling the recovery from 5048 to 5141 before close at 5122. Our strategy was not to stay “long” at 5075-5175 with an intention to keep building shorts on signals of dilution in upside momentum which could extend up to 5175 with solid resistance at 5200 staying firm. There are no cues as yet to expect solid stimulus support from the FED or ECB; the resultant disappointment will drive the market down below 5000 to our near/short term objectives at 4775/4550. The extent of stimulus support in the western economies will make things difficult for quick revival; this is seen as temporary fillip and not permanent solutions for recovery. For now, let us watch 5000-5200 and await sharp reversal below the lower end for 4775/4550 in due course. We shall not stay “long” till reversal into 4775-4550 is seen. Strategic investors can continue to stay invested in Fixed Income as emergence of sustainable bullish trend is distant away.

Good luck....................................Moses Harding