Shift of economic woes from the West to the East......Cash is king
It has been a roller coaster ride since 2001. First, there was economic prosperity for the East from the West; then shift of economic power to the Emerging markets and now spill over of economic woes of the West to rest of the World. The global economic capacity expanded multi-times during this period for overall financial prosperity. The reversal of good times since 2008 triggered by financial crisis in the US extended into financial and sovereign crisis in the Euro zone; and now threatening the economic viability of the emerging nations. Given the magnitude of the crisis, it is obvious that there are no quick-fix solutions; revival process will be a long-drawn struggle, thus causing severe damage to the investor and consumer confidence. The resultant impact on the global economies and market will be very negative. The built-up capacity will go idle with global economy shifting into below par capacity. There is no case for capacity expansion; hurting job and wealth creation. The fiscal capability of the Governments will come under pressure; squeezing government expenditure and exerting downward pressure on growth momentum. The capacity to invest and consume will be down significantly; thus impacting the top-line and causing margin squeeze. Over all, the market dynamics are complex and roll-out of viable supportive measures seems difficult at this stage. The only positive factor is the hope of joint actions by the West and Emerging economies to save the globe from economic disaster!
What do these mean to global markets? All assets classes will be under pressure. The credit spread; liquidity premium and tenor spread is already high in the Western markets. EMs are in better shape right now; but there are strong signals that impact will be felt soon here in the absence of flow of liquidity and consumer demand from the West. The worst hit will be equity assets with pressure on top-line business; profitability and growth momentum. The shift into sustenance mode in the global economies, real estate assets will come under severe pressure. Economies maintaining deficit in Trade and Current Account will face severe pressure on domestic currency. The resultant impact on the inflation and the need to maintain affordable interest rates to support growth will push up liquidity premium and tenor spread; thus setting up extended bearish run on medium/long tenor fixed income. The market dynamics are mixed in commodity assets. Gold is likely to retain its safe haven status in the absence of confidence on the West; US Dollar has lost its default safe-haven status and investors have very little option to choose. Taking all these together, it will be prudent to stay away from equity; real estate and medium/long term fixed income. There is risk of losing time value and erosion in asset value. The most sensible investment strategy seems to be stay in cash and park them in high yielding short term fixed income assets. There is guarantee of positive returns; the strategy is to stay conservative (low credit risk/low return) when the road ahead is complex and unclear. Investors’ preference will be for sovereign bonds, Bank Fixed Deposits and Gold.
What is the near term impact on markets?
Currency market
Rupee almost met the first target of 51.50 (low of 51.40) and shifted quickly from the lower end to higher end of set short term range play at 49-52. The fundamentals and market dynamics continue to remain bearish. There is severe pressure on trade/current account; flows into debt capital market is down and not expected to revive soon; FII flows into equity capital market will be down not ruling out reverse flow ahead of their financial year end; forward segment is in one-way demand driven mode with exporters not attracted by lower FX premium and absence of comfort on rupee stability/appreciation; risk of slippage of growth momentum below 7%; inflation continue to stay at elevated levels on higher commodity prices and weak rupee and more importantly fear of downgrade by global rating agencies on shift of economic woes from the West to Emerging markets. Having said these; current depreciation of rupee from 43.85 to 51.40 since August 2011 is excessive. It would be prudent to allow for consolidation till we get clarity on pipe-line supportive measures by IMF/ECB for revival of the Euro zone. The preference is for consolidation at 50-52 in the near term. Given that it would take a very long time for rupee getting back into appreciation mode; strategy for exporters would be to sell 1-3M dollars on spot weakness into 51.75-52.25 while importers stay away for correction back into 50.25-49.75 to cover 3-6M dollar payables. While it is essential for RBI to supply dollar liquidity into the system to drive the forward segment into supply-driven mode; it is unfortunate that there is not enough rupee liquidity in the system for this action. A quick-fix solution to arrest rupee weakness beyond 52 is by pushing the 3M premium into 7% and 12M into 5%. There seems to be no solution at this stage to address both rupee and dollar liquidity squeeze without one impacting the other in the absence of RBI’s ability to effect aggressive CRR cuts or conduct large OMOs. So, there is no conviction at this stage to look for sharp reversal below 50 and may not be a good risk-reward to chase extended weakness beyond 52. While it is considered good for near term consolidation play at 50-52, the risk of extended weakness beyond all time low of 52.18 is very much in play if not now, definitely into the short term. For the week, let us watch consolidation at 51.00-51.80 with overshoot limited to 50.65-52.15. It is not wishful to expect all-time low of 52.18 to remain safe in the near term.
EUR/USD moved into the sell zone of 1.3550-1.3650 (high around 1.3615) and USD/JPY down into the buy zone of 76.75-76.25 (low around 76.55) before close of week at 1.3525 and 76.90. Market is in wait-and-watch mode to get clarity on roll-out of stimulus and supportive fiscal/monetary/financial packages. It is also obvious that these measures could at best squeeze the credit spread and liquidity premium but not confirm a quick revival. These expectations into the near/short term will keep the market in consolidation mode for now before setting up directional break-out. Let us stay with the set near term range of 1.30-1.40 in EUR/USD and need to be prepared for two-way volatility driven by news and data. It is prudent for strategic investors to stay aside to get more clarity on directional break-out leaving the floor to fleet-footed traders who can afford to play end-to-end with tight stop on test/break thereof. For now, let us watch EUR/USD at 1.3350-1.3650; while the bias is for extension of Euro weakness into 1.3150-1.3000, cannot rule out gains into 1.3800 before down. USD/JPY will stay in consolidation mode at 76.25-77.50. The downside risks for USD is low (not beyond 75.50) with higher probability of gains into 79.50-80.00. Strategic players can look to sell into Euro weakness at 1.3650-1.3800 (for 1.3150-1.3000) and buy USD/JPY at 76.50-75.75 (for 79.50-80.00).
It was not a surprise to see sharp reversal in FX premium from the set strong resistance/receive zone at 6% in 3M and 4% in 12M but extension below 5% (into 4.5%) in 3M and below 3.5% (into 3.25%) in 12M was unexpected and thus excessive. It was mainly on strong exchange rate play while interest rate play turning neutral on being even on rupee and dollar liquidity squeeze. What next? The exchange rate play on extended rupee weakness into 51.90-52.15 would exert downward pressure on premium but extension below 4.5% (3M) and 3.15% (12M) is not expected to sustain. It is time to unwind 3M receive book entered at 5.75-6.0% at 4.5-4% to shift PCFC funding back into dollar sources (and release rupee liquidity) while 12M premium move into 3.15-2.90% is too good to ignore for raising cost effective rupee sources from dollar uses. For now, let us watch 3M at 4.0-5.0% and 12M at 3.0-3.5% and not advised to chase extended weakness below the set lower end. This sets up strong support in 3X12M at 2.5% (98) which is a good interest cost effective strategy for dollar import funding on fully hedged basis. 3X12M has slipped into 2.75% from 3.25% which is difficult to sustain; hence importers can use this as hedge while waiting for spot reversal into 50-49 (to buy 3M dollars).
Commodity market
Gold reversal from 1790-1810 is holding well above strong support at 1710 (ahead of 1680). Till clarity emerges on rescue packages in the US and Euro zone; sideways consolidation mode is expected to prevail within 1680-1760. Over all, given the strong downward pressure on most asset classes; Gold will retain its safe-haven preference. Strategic traders can look to buy at 1710-1680 with tight stop for 1790-1810. The reversal in NYMEX crude from 103 has extended below 98. The break-out from comfort zone of 80-90 into 95-105 is triggered by tensions out of Iran. Any resolution there would drive the market back into 80-90 while G20 will work to arrest bull rally beyond 103-105. Taking all these together, it would be a low risk; high reward trade to sell in two lots at 99-101 and 103-105 (with stop at 106) for 90-85. For now, let us look for consolidation at 95-100 with bias for test/break of lower end into 93-90.
Bond/OIS market
The signals in the Money Market are mixed. The focus has shifted from interest rate to liquidity (and fiscal deficit). The upward pressure on rates/yields is in play triggered by liquidity squeeze driven by huge pipe line demand for funds from RBI (week-on-week bond supplies) and shift of FC credit to rupee credit. On the other hand, the need for RBI to keep H2 Government borrowing at affordable cost and to counter growth pressures; we can safely assume that market has seen the end of rate hike cycle. But, high inflation; weak rupee and high commodity prices continue to remain as risk factors to trigger rate (and/or CRR) cut. However, bias is in favour of rate cut and liquidity infusion sooner than later. The system liquidity squeeze of dollar and rupee has struck at the same time, making things difficult for RBI to address bearish trend both in currency and bond market. A one-shot solution to address both together is tough. Given these factors in play, Bond market is boxed between rate cut expectations (to arrest run-away weakness) and huge supplies from RBI (to limit excessive gains); thus had set up consolidation play in 10Y bond at 8.75-9.0%. We have seen end-to-end moves of this range and now trading at 8.83%. The strategy of buying into weakness at 8.90-9.0% (for OMO) and sell into 8.80-8.75% (for RBI auctions) stays valid. FII’s interest in the shorter end of the curve will limit weakness in 1Y bond yield above 8.85%. For the week, let us watch consolidation in 1Y at 8.75-8.85% and 10Y at 8.75-8.90%.
OIS rates having come off from the resistance/receive level above 8.35% (1Y) and 7.50% (5Y) has now settled into support/pay zone at 8.10-8.05% (1Y) and 7.30-7.25% (5Y). For reasons discussed above, we look for consolidation play at 8.0-8.20% in 1Y and 7.15-7.40% in 5Y. The bias into the near/short term is for squeeze in the 1X5 spread and we need to be prepared for this; thus the strategy is not to chase 1Y above 8.15% and 5Y below 7.10%. The trade for now is to receive 1Y at 8.15-8.20% (for 7.90%) and 5Y at 7.35-7.40% (for 7.15%). Thereafter, we will fix the 1X5 strategy.
NIFTY
The set first objective of 4850 is met (low of 4837); thus completing end-to-end of set near term range of 4850-5350. Now, we would allow bit of consolidation before meeting the next target at 4700 as we now watch near term play at 4700-5000 with overshoot limited to 4650-5150. The outlook for equity asset class is very negative triggered by weak domestic cues driven by low growth; high inflation; tight liquidity and high interest rates. The risk is also from pass through of economic woes from the West into Emerging markets. There is build up of strong bearish play driven by both domestic and external sectors. Having said these, weakness into 4700-4650 will be good to open the investment account for strategic investors. For now, let us watch consolidation at 4850-5000 in preparation of gaining momentum for 4750-4725. The near term trading strategy is to sell in two lots at 4950-4975 and 5025-5050 (with stop at 5075) for 4750-4700.
Moses Harding
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