Weekly report for 25-29 June 2012

MARKET PULSE: Weekly report for 25-29 June 2012

Operation “Reverse TWIST” can restore confidence for short term rupee target at 52

It was an eventful week and one of the worst for rupee. It started with post-monetary policy disappointment, followed by FITCH downgrade of sovereign rating outlook from stable to negative, FOMC delivering to expectations reaffirming its near zero interest rates stance till 2014 and extending “Operation TWIST” to end 2012 with financial package of $267 Billion. ECB also extended and reaffirmed financial support to Euro zone through purchase of sovereign bonds in the secondary market and funding support to Banks. The disappointment for many was from RBI’s pause mode and hawkish monetary stance and to some on non-delivery of QE3 by the FED. The impact on asset markets was neutral except for sharp fall in rupee exchange rate. Rupee fell sharply from pre-policy high of 55.26 to post-policy low of 57.33 before close of week at 57.12. In the meanwhile, BRENT Crude fell sharply from weekly high of 99.50 to low of 88.49 before close of week at 90.98. The downtrend in commodity prices is to expectations despite loose monetary policy. Commodity prices are sharply down in 2012 on lack of confidence into the future tracking loose fiscal policy and recessionary/stagflation trend in the Global Economy. China is also showing signs of deceleration in growth momentum and Japan is into Current Account Deficit mode. The expectation of support from the EDM group (Emerging and Developing markets) to the global GDP is under threat. There is no risk of sharp reversal in commodity prices and expected to stay in consolidation mode (with mild downward bias) till signals of global recovery is sighted, which seems to be distant away. This will be good for economies importing crude oil and run Current Account Deficit while it is serious threat for oil exporters who have enjoyed extended run since 2008.

Rupee’s fortunes depend on the ability to address issues relating to growth, inflation and twin deficits in fiscal and Current Account. The fear of CAD (as risk to rupee) is now out of the way on sharp downtrend in commodity prices with possible 30% cut in the oil import bill in dollar terms. It will be good if Oil Marketing Companies look to hedge FY13 imports on extended weakness in BRNET into $75-85. It is also possible that weak rupee will reduce non-essential imports and reduce consumption of essential imports, thus expected to release pressure on the demand side of CAD. It is also possible that highly overvalued rupee will help exports into the short/medium term. The twin advantage for rupee at this stage is the release of pressure on CAD and highly over-valued USD. Why bearish set-up on rupee? There are two reasons: one, weak macro fundamentals and fear of sovereign rating downgrade and the other is the accounting issues related to hedging of export contracts; one leading the dollar demand and the other lagging dollar supplies causing severe pressure on an otherwise dollar demand-driven market. Most exporters who have covered dollar receivables for FY13 (at spot 44 to 52) are at risk of huge mark-to-market provision in their quarterly results. It is now a trade-off between taking a P&L hit or buy highly undervalued forward rupee; most prefer to protect P&L to covering exchange rate risk when there are no signs of bottoming out signals of rupee weakness. Most exporters end up providing opportunity loss in the P&L account. On the other hand, real losses from uncovered import (and FC liability) exposures are directly taken into the top-line only on maturity of the exposure while mark-to-market losses are ignored.

The risk of rating downgrade emanates from the fear that unless the system shifts to favourable monetary dynamics, issues related to growth and fiscal deficit are difficult to be resolved. It would be worse with unfavourable political and external environment. It would also need stable (and strong rupee) to get the benefit of weak commodities on inflation. The benefit from sharp fall in BRENT Crude from $126 to $99 since Euro zone crisis is completely undone by fall in rupee from 44 to 57. Indian economy stands out in its monetary stance while others are into excessive loose monetary policy to arrest recessionary trend and deceleration in growth. The issues of high Current Account Deficit and high inflation is also unique for India and with this disadvantageous position, it is hard to get into the right side of rating agencies. It is necessary to shift into accommodative monetary stance to provide comfort on growth and fiscal deficit. There is strong linkage between growth and fiscal deficit and growth issues have to be addressed first to get into fiscal consolidation.  RBI is not expected to get into rate cut mode till headline (and expectation on) inflation turn favourable. FED supports the US monetary system through “Operation TWIST” (after exhausting options on rates and direct liquidity through QEs) by selling short bonds and buying long bonds to arrest spike in long term yields at the cost of marginal spike in the shorter end. The scenario in India is different; shorter end of the rate curve is up with a downward slopping to flat in the mid to longer tenor. The need is to exert downward pressure in the shorter end and provide stability (with marginal upward bias) in the mid to longer end to make rate dynamics supportive to growth without rate action. It could be done by liquidity injection through CRR cut and OMO bond purchases or “Operation Reverse TWIST”; buying bonds in the shorter end and selling in the longer end. If this action is followed by guidance on shift in operative policy rate from Repo rate to Reverse Repo rate through shift of stance by RBI to maintain system liquidity in surplus mode within 1% of NDTL, there will be significant squeeze between overnight MIBOR and 1-2Y Bond yield. It is all about confidence and bullish expectation into the future and it is difficult in the absence of growth supportive monetary policy. This could provide trend reversal in rupee from above 57 to below 52.

Currency market

Rupee weakness moved past the higher end of the range at 57.15 but fell short of the stop/reverse set at 57.35 (low of 57.32) before close of week at 57.12. Rupee lost its traction with USD Index post monetary policy; while EUR/USD moved up from 1.2550 to 1.2750 and back at 1.2550, rupee was in one-way move from 55.26 to 57.32. Ideally, rupee should have extended gains below 55.25 (on its reversal from 56.52) to 54.50 (tracking EUR/USD from 1.2550 to 1.2750) and should have been in consolidation mode around 55 in the worst case. But now it is above 57 and that is the kind of bearish set up on rupee with dollar demand over-run in the market. What next? Rupee is highly overvalued and 30% fall in BRENT Crude has to get factored in rupee exchange rate. There is no risk of reverse flow in capital account but for pipe-line FCCB repayments. It is important for RBI to prevent the worst and engineer sharp unwind of recent fall from 54.92 to 57.33 (since 7^th June to 22^nd June) to get the rupee bulls on street. It is now believed that RBI is alright with weak rupee if it could support addressing issues concerned with CAD, in which case, the next downside targets for rupee is at 57.90 ahead of 58.25-58.50. The immediate support for USD/INR is at 56.75 (ahead of 56.40) and further into 55.85-55.50 which could be a strong near/short term base for the pair. For the week, let us watch 56.40-57.90 with extension limited to 56.15-58.25. The strategy is to buy 1-2M payables on rupee gains into 56.40-56.15 and sell long term dollar receivables on extended rupee weakness into higher end. 7Y forward dollars at value above 80 (current at 77.50-78.50) is good to convert rupee liabilities into foreign currency. For today, rupee is expected to stay in consolidation mode at 56.75-57.35 and would prefer test/break of lower end into 56.40-56.15.

EUR/USD nicely played end-to-end of 1.2525-1.2500 (low of 1.2518) buy zone and 1.2725-1.2750 (1.2747) sell zone before close of week at 1.2568. It was a perfect “buy the rumour; sell the fact” syndrome as pre FOMC rally to 1.2750 was completely unwound post FOMC. However, FED’s stance of keeping QE3 expectations warm provided support to EUR/USD above 1.25 to prevent extension into 1.2250. What next? In the absence of any negative cues this week, EUR/USD is expected to hold above strong support at 1.2425-1.2450 with marginal bias for test/break of 1.2750 into 1.29. For the week, let us watch 1.2500-1.2750 with bias into higher end not ruling out extended gains into 1.2850-1.2925. The strategy is to buy on dips into 1.2525-1.2450 (with stop at 1.2425) for 1.2725/1.2875. It is also good to sell at 1.2875-1.2925 (with stop above 1.2950) for 1.2525-1.2475.

The reversal in USD/JPY from 79.75 found support above 78.75 for extended rally into 80.50 before close of week at 80.40. The widening Current Account Deficit in Japan and negative outlook on Chinese growth momentum will keep the JPY weak both against USD and EUR. For the week, let us watch USD/JPY at 80.00-81.75 with bias into higher end. The strategy is to buy at 80.25-79.75 (with stop at 79.50) for 81.50-81.75. EUR/JPY too has rallied sharply from 99 to over 101 and looks good for extended gains into 103.25-104.25. The strategy is to trade end-to-end of 100-104 with tight stop on break thereof.

Interest rate market

It was volatile week in the Bond market. 10Y Bond yield was sharply up from pre-policy low of 7.95 for post-policy weakness into 8.20% before down again to 8.0% on OMO support before close of week at 8.09%. It was a nice end-to-end move within 8.0-8.20%. Our strategy to unwind long on extended gains into 8% and stay invested at discount has proved good. The outlook is neutral to negative and sharp gains in 10Y Bond into 8% will be stretched, hence not expected to sustain. On the other side, there is risk of extended weakness beyond 8.15-8.20% if RBI decides to cut bearish outlook on markets with surprise CRR cut (and “Operation Reverse TWIST”). For the week, let us watch consolidation at 8.0-8.20% with test/break either-way not expected to sustain. The strategy is to trade end-to-end and stay invested at 8.18-8.23% for short/medium term rally post downtrend in headline inflation.

The monetary policy disappointment drove 1Y OIS rate up from 7.54 to 7.86 before close of week at 7.77% while 5Y rate was up from 7.17 to 7.36 before close at 7.20%. What next? There is more clarity in the 1Y as the bias is for move into pre-policy low of 7.45% while move into 7.85-7.90% will set up good receiving opportunity. The focus will now shift to 1X5 spread play to squeeze the 1X5 spread below 50 bps (which is currently in consolidation mode around 55 bps). On the other hand, 5Y OIS rate below 7.15% is tough to hold for gradual push into 7.35-7.40%. For the week, let us watch 1Y at 7.55-7.80% and 5Y at 7.15-7.35%. The strategy is to stay received in 1Y at 7.78-7.83% (with stop above 7.85%) for 7.55-7.45% and pay 5Y at 7.15-7.10% (with stop below 7.08%) for 7.33-7.38%.

FX premium eased from recent high of 7.25% (3M) and 5.75% (12M) for close of week at 7% and 5.4% respectively driven by exchange rate play tracking sharp spike in USD/INR above 57. What next? The interest rate play will turn bearish to exert downward pressure and the directional guidance will be from exchange rate movement. Given the risk of extended weakness in rupee into 58, bias can be lower but sharp reversal into 55.50 and beyond in the near term will keep bullish trend intact. It is important for FX premium to stay at elevated levels till rupee fears are completely out of the way. For the week, let us watch consolidation at 6.50-7.25% (3M) and 5.25-5.75% (12M). The strategy is to play end-to-end and test/break either-way is not expected to sustain.

Equity market

NIFTY retained its pre-policy rally into post policy (despite disappointment) for push from 5041 to 5170 before close of week at 5146. In the meanwhile, DJIA fell from intra-week high of 12899 to 12561 before close of week at 12640. The rating downgrade of Banks and FED delaying the roll-out of QE3 caused bit of damage for US markets. NIFTY weekly close above 5075-5100 support is bullish but inability to take out 5175-5200 is a concern. Having said these, it is indeed a pleasant surprise for NIFTY to stay here despite weak rupee, hawkish monetary stance, risk of sovereign rating downgrade and general lack of confidence on the Indian economy in the short term. The global bourses will get into consolidation mode in the near/short term on strong stimulus support but medium/long term outlook is suspect. A nice trading range is set in DJIA at 12000-13500 with bias into higher end. The June rally in NIFTY from 4770 to 5190 was superb despite sharp fall in rupee from 54.92 to 57.32; hawkish monetary stance and delivery of rating watch by S&P and FITCH. The reason for sustainable rally could be sharp downtrend in BRENT Crude which will be a great advantage for India into the medium/long term while aggressive injection of liquidity in Western economies and highly undervalued rupee attracting FII interest. The momentum now looks good for extended gains over 5200 to get the focus into 5300/5450 while 5100-5075 stays firm. For the week, let us watch 5100-5300 with bias into higher end. The strategy is to buy dips into 5100-5075 (with stop below 5050) for 5275-5300. It is not clear at this stage whether NIFTY could extend its rally into 5630 to complete 100% reversal of recent fall from 5630 to 4770.

Commodity market

It was a perfect “buy the rumour and sell the fact” action; pre FOMC rally from 1525 to 1640 reversed sharply post FOMC into 1558 before close of week 1571. It was also disappointment for the commodity market not to see the roll-out of QE3. So, it is back to consolidation at 1525-1640 with bias into 1500-1475 before sharp reversal. There is no change in view of formation of strong base at 1525-1475 for strong short term rally. For the week, let us watch 1525-1590 with bias into lower end. The strategy is to stay short for this move for lower end to complete end-to-end of set near term range of 1525-1640.

NYMEX Crude almost hit the set short term objective at 75 (low of 77.56) before close of week at 79.76. We may need to allow for bit of consolidation after this strong move from 110 to 77 before possible visit to 65 which is seen as strong short/medium term base. For the week, let us watch consolidation at 75-85 with test/break either-way to attract. The strategy is to sell at 83.50-85.50 (with stop at 86.00) for 75.50. NYMEX Crude price has discounted the global economic gloom but there is risk of bullish reversal into 90 on QE3. But, not expected to move beyond 90 to set up a short term range play at 65-90. After a $30 chase from over 110 to below 80, need to stay prepared for the next $20-25 chase from 90 to 65.

Have a great week ahead....................................Moses Harding