MARKET PULSE - 15 DEC 2011

Market Pulse – 15 December 2011

Currency woes to delay shift into dovish monetary stance

The market was looking for a quick reversal in RBI’s monetary policy stance. The shift from high growth; high inflation regime to moderate growth; moderate inflation called for pause mode ahead of shift into start of rate reversal cycle. The sharp depreciation in rupee by 23% since August 2011 has put the economy to risk of move into low growth; high inflation scenario. The worst for rupee is still ahead; that puts RBI in back foot. The benefit of base effect (for headline inflation) will be significantly diluted on higher input cost of imported items. While the food price inflation has come down sharply; fuel and core inflation is likely to stay at elevated levels and going forward, impact will be felt on food inflation as well. The higher subsidy element will cause further slippage in fiscal deficit. The impact of sharp depreciation in rupee will lead to downtrend in growth momentum below 7% and elevated headline inflation at above 8% by March 2012. It is obvious to conclude that “pause stance” of RBI may be an extended one into March 2012 and it would need sharp reversal in rupee into 49-51 to remove rupee impact on headline inflation. This combined within reversal in commodity prices will release the pressure on RBI. Till then, RBI is expected to stay with pause mode with the risk of back into hawkish stance if rupee extends its weakness beyond 56. Therefore, expectation of CRR cut now (and rate cut thereafter) has shifted to risk of rate hike if rupee continues its free fall. RBI is expected to keep CRR and policy rates unchanged and may not sound dovish on the way forward. RBI is expected to stay cautious on inflation (and rupee woes) and look for improvement in the external sector to address growth issues.

Currency market

Rupee fell into the last line of defence at 53.75-53.90 (low of 53.88) before close at 53.71. RBI did its best to prevent extended weakness over 54. The sharp fall from 48.61 to 53.88 since 1^st November is cause for serious concern while RBI is working to bring down the headline inflation into 7% by March 2012. In the meanwhile USD Index held well above 78.20 into over 80.50 and looking good for further extension over 81. The outlook for rupee continues to stay bearish given the strong downtrend in EUR/USD (below 1.2850 into 1.20) and NIFTY (below 4650 into 4250). There are no signs as yet for importers to hold back dollar demand and exporters to accelerate dollar supplies. The market is aggressively in demand driven mode; it should shift to neutral to complement RBI’s dollar supplies into the market. Till then, RBI’s intervention may not be effective and at best could delay the inevitable move into 56-58. Now, we revise the short term range from 51-56 into 53-56. The next support levels for rupee above 54 are at 54.50/54.90/55.25 ahead of 55.55/56.00. It is difficult to set a reversal point for rupee at this stage. RBI would need to think of measures other than intervention to halt run-away rupee weakness. RBI did well through its monetary actions to establish downtrend in inflation. But, rupee weakness may undo all the good work of RBI in its fight against inflation. This is the big worry for the economy; shift into low growth and high inflation will be an economic disaster. For now, let us watch 53.50-54.50; it would need EUR/USD holding its weakness above 1.2850 and NIFTY finding support at 4650 to avoid extended weakness into 54.90-55.25. Given the strong bearish set up both in domestic and external sectors; expecting a strong reversal is wishful at this stage. Now, all attention is on RBI on its measures (and actions) to defend rupee above 54 and provide reversal into 53-51 to guide near term stability at 51-54. Till then, reversal into 53.50-53.15 will attract importers’ interest (with stop below 53) while exporters are expected to hold back for 54.90-55.25 (with stop below 53).

EUR/USD is in firm downtrend and has moved into the lower end of set short term range of 1.2850-1.4150 (low of 1.2944 so far from high of 1.4247). The test/break of lower end will open up a swift move into 1.2600-1.2550 ahead of 1.1900-1.1875. At this stage, we cannot rule out reversal into 1.3250 before getting into downtrend. So, it would be good to “short” EUR/USD at 1.3050/1.3150/1.3250 for the next 1000 points move into 1.20-1.1850.  For now, we look for consolidation at 1.2850-1.3050. In the meanwhile, USD/JPY looks bid for extension into 78.75 while 77.75 is expected to stay firm.

The shift of interest rate play post weak inflation data pushed 3M premium into 6.25% and 12M into 4.6%. The strong bearish undertone on spot rupee and base effect (of higher spot) has caused test/break of strong resistance at 6% in 3M and 4.5% in 12M. This move is good for RBI as higher premium could get the forward market into supply driven mode or at the worst, cut the demand for forward dollars. The risk of test/break of over 6% in 3M and over 4.5% was flagged in the previous report as premium lost traction with exchange rate play (losing the downtrend despite higher spot rupee). For now, let us watch 6.0-7.0% in 3M and 4.5-5.0% in 12M with bias for move into higher end. The delay in rate reversal cycle will keep the upward momentum intact.

Bond/OIS market

The strategy to unwind “long bonds” on extended gains below 8.45% (10Y) and “received book” in OIS at 7.70-7.75% (1Y) and 6.95-7.0% (5Y) on run into monetary policy proved good. The weak inflation number and risk of rupee impact on inflation pushed 10Y bond yield up from 8.41% to 8.52% and OIS rates sharply up from 7.70% to 7.80% in 1Y and 6.96% to 7.07% in 5Y. What next? Now, the way forward is clear. There is no case for RBI to shift into dovish monetary stance. The risk is of now Indian economy shifting into low growth; high inflation scenario. While there is clarity on downtrend in growth momentum below 7%; rupee depreciation by 25% in 4 months (and worst not yet in sight) will keep the headline inflation above 8%. There will be further pressure on trade gap and fiscal deficit. Rupee has now become pivot for RBI’s monetary stance. Given the inability of RBI to defend rupee; its impact on inflation is a serious worry. Having said these, RBI would need to pump in rupee liquidity to create room for aggressive dollar sales. RBI also cannot allow the rupee to find its own “floor”. It is indeed complex and caught between the devil and deep sea. In the event of rupee having a free fall beyond 56; the risk is of RBI shift into rate hike mode to arrest rupee fall. For now, let us watch 10Y bond yield at 8.45-8.60%; 1Y OIS rate at 7.75-7.90% and 5Y OIS rate at 7.05-7.20%. While the bias is into the higher end; RBI’s preference for OMO to pump rupee liquidity will limit extended weakness beyond higher end. However rupee weakness beyond 56 will get the focus back into 8.75% (10Y bond) and 7.40% (5Y OIS); not ruled out at this stage.

Commodity market

Gold moved sharply down to meet the set objective at 1600-1580 for extended weakness into 1564. In the meanwhile NYMEX crude lost steam around 100 for reversal below 95 (low of 94.21). Given the strong US Dollar and recessionary fears in the global economy; commodity assets will continue to be in downtrend. The next pit stop for Gold is at 1535-1485 and NYMEX crude into 93-90. For now, let us watch 1500-1600 in Gold and 90-97 in NYMEX Gold with immediate bias for move into lower end. Staying short with stop above 1610 and 98 would be good at this stage.

NIFTY

NIFTY traded end-to-end of 4750-4850 (high of 4839 and low of 4750) before close at 4763. The rally from 4639 to 5100 on expectation of shift into dovish monetary stance by RBI is not relevant now. The risk is of extended pause mode or trigger of next round of rate hike come into play to set up firm bearish play in the equity market. We await test/break of 4639 in preparation for extended weakness into 4350-4250 in the near term. For now, let us watch 4600-4800 with bias into the lower end.

Moses Harding