Stalemate in the Euro zone....needs to avoid deadlock
The much awaited EU summit is out of the way with no “feel good” vibes. While there was commitment to provide monetary support through infusion of liquidity and maintaining low interest rates for extended period of time; issues on the fiscal measures remain stalemate and it is important that it should not get into a deadlock. Moreover, stringent fiscal measures (if agreed) will be not only tough to implement (and execute) but may not be good for economic development into the short term; it could at best prevent the worst and it would be a very long haul to get the economy into growth trend into medium/long term. It is back to consolidation mode in the global markets; monetary/financial support will arrest run-away weakness but there is not a single factor to get the markets into bull phase. It is now time for global rating agencies to trigger downgrades of Euro zone countries and put rest of the economies is rating watch. Over all, asset markets (including commodities) will stay under pressure while the greenback retains its safe-haven status.
Let us now study near/short term impact on markets:
Fixed Income/Bond/OIS market:
Money Market rates stay steady at 9.25-9.75% across 3-12M tenor despite tight liquidity and high overnight rate. The firm establishment of downtrend both in inflation & growth and the need to keep the system liquidity in adequate mode to meet higher fiscal deficit has already set up down trend in money market rates. The immediate agenda for RBI is to release liquidity to bring drawdown from Repo counter to less than 1% of NDTL. The immediate concern is to cover advance tax outflows and higher demand for funds on run into new reporting fortnight starting 17th December. Given that OMO bond purchases is liquidity neutral (matched with week-on-week bond supplies) and RBI in USD sell mode in FX market (sucking out rupees from the system); delivery of 0.5-0.75% CRR cut is required to arrest price volatility. However, this action (of CRR cut) could at best maintain price stability at current levels as operative policy rate will continue to remain at the higher end of LAF corridor. The downward shift in MM rate curve will be on injection of additional liquidity to get the system into 1% NDTL surplus mode (to drive operative policy rate to lower end of LAF corridor) and shift of RBI into rate cut mode. The market is expected to move into this scenario by January-March 2012. Over all, the worst is already behind us and the market prepares to get into soft interest rate and adequate liquidity mode. The expectation is for shift of 3-12M money market rate curve into 8.5-9.25% in the next couple of months.
The confirmation in downtrend in inflation and growth (and the need for RBI to reverse its hawkish monetary stance) has already pushed the 1Y bond yield from 8.85% to 8.25% and 10Y bond yield from 9.0 to 8.5%. In the meanwhile 1Y OIS rate is down from 8.35% to 7.75% and 5Y OIS rate down from 7.5% to 7.0%. The swift move in the bond and OIS market has taken into account 50 bps cut in CRR and rate cut soon thereafter, latest by January-March 2012. It is important that RBI delivers these expectations to provide price stability at current levels. It was in order for 10Y bond weekly close at 8.53% (up from low of 8.49%); 1Y OIS rate close at 7.81% (up from 7.73%) and 5Y OIS rate close at 7.09% (up from 6.99%). The strategy not to chase gains below 8.5% (10Y bond); 7.75% (1Y OIS) and 7.0% (5Y OIS) has proved good. What next? The market will be in tight consolidation mode on run up to monetary policy. It will be sideways trading mode at 8.48-8.58% (10Y bond); 7.75-7.90% (1Y OIS) and 7.0-7.20% (5Y OIS). The market will be nervous ahead of 16th December weighing the risk of consequences if RBI prefers to leave things unchanged; which will drive the 10Y back into 8.65-8.75% and 5Y OIS into 7.25-7.35%. We do not expect this stance from RBI at this stage given the global uncertainties and in thin December market. Having squared positions on run into 8.5%; 7.75% and 7.0%, it is good to start absorbing weakness (from now on) but to stay light keeping good room to add on extended weakness. The strategy is to stay long bonds in 1Y at 8.30-8.40% and in 10Y at 8.55-8.60%. We are already paid in 5Y OIS (first lot) at 7.0%; add the second at 7.05% and third at 7.0% (with stop below 6.95% and t/p at 7.15%).
Currency market
We had looked for consolidation in USD/INR spot at 51.50-52.50 taking into account strong bearish set up in rupee and RBI’s concerns to arrest excessive weakness to prevent rupee impact on downtrend in inflation. Accordingly, we asked to buy reversal in USD/INR into 51.50-51.35 and 51.20-51.05 (with stop below 51) and sell rally into 52.10-52.20 and 52.35-52.50. The market moves were as per script as initial gains halted at 51.19 for sharp reversal into 52.35 before close of week at 52.03. In the meanwhile USD Index was supported well above 78.00-78.20 for rally above 79.00. What next? We continue to watch consolidation at 51.25-52.75 (within 51-53). The risk of extended weakness into 54-56 is still valid while gain below 51 is very difficult to sustain. These expectations set up a short term range play at 51-54; let us evaluate extension to 56 when rupee posts a new historic low. For now (and into the near term); let us continue to watch consolidation at 51.50-52.50. Strategy for exporters is to sell 3M dollars at 52.35-52.50; 3M FX premium at 5.75-6.0% makes 3M forward dollars at 53.15-53.25 attractive and to push shorter end of the forward market into supply driven mode. On the other side reversal into 51.75-51.65; 51.50-51.35 and 51.20-51.05 will attract importers’ interest to cover 1-3M payables; 3M forward dollars at below 52.35 looks cheap given the huge downside risks to rupee.
EUR/USD is tightly boxed at 1.3250-1.3450 with no momentum to guide test/break either-way. We have seen end-to-end moves within this range many times but it is time to get out of this range. USD Index is set to extend its gains into 79.60-79.85 and thereafter gain momentum for swift run into 81. This expectation puts 1.3250 to risk for sharp rally for dollar into 1.30-1.2850. Having said this, liquidity support in the Euro zone could give bit of relief to Euro but such a rally in EUR/USD should fail at 1.3525-1.3625. For now (into the near term), we watch play within the “inner ring” of 1.3250-1.3450 with overshoot to stay within 1.3150-1.3550.
USD/JPY is in sideways trading mode at 77-78 with downward pressure in the absence of BOJ. More the delay in taking out immediate resistance at 78.00-78.25, the risk of extended weakness into 76.75-76.50 is valid. It is also possible that any gains over 78.25 may not sustain above 79.50; thus setting up short term range play at 76.50-79.50. For now (into the near term), we watch play within the “inner ring” of 77-78.25 with overshoot to stay within 76.50-79.50.
FX premium is in firm uptrend despite strong downward pressure from interest rate play; thus losing its traction with bond/OIS market. The strong bearish set up in rupee has also cut the exchange rate play driven by one-way demand driven mode in forward market with momentum from FII interest (to hedge short term investments) and improvement in the availability of dollar liquidity. The close of week at 5.9% (3M); 4.4% (12M) and 3.9% (3X12M) is bullish. Now, 3M is expected to hold at 6% (attracted by supplies from exporters and shift of export credit from dollars to rupees) and the pressure will be in 12M and 3X12M. Let us stay aside for now and watch consolidation at 5.75-6.0% (3M) and 4.25-4.5% (12M).
Commodity market
Gold traded end-to-end of 1710-1760 range (low of 1701 and high of 1754) before close of week at 1711. The downward momentum from close to 1760 into below 1710 was swift but recovery from there was shallow; thus setting up a firm downtrend into the near term. Now, there is good chance of correction into 1680-1665 while move into 1725-1730 attracts selling interest. For the week, let us watch consolidation at 1665-1730 with bias for moving into 1675-1665 but test/break thereof is not expected to sustain.
NYMEX Crude traded end-to-end of 98-103 range (high of 102.44 and low of 97.36) before close of week at 99.41. Here again, there is dominance of bearish momentum for extended weakness into 95 while move into 101.75-102.50 attracts supplies. For the week, let us watch consolidation at 97-102 with bias for test/break of lower end into 95 which should hold.
NIFTY
NIFTY traded end-to-end of set near term range of 4850-5150 (high of 5099 and low of 4841) before close of week at 4866. The global sentiments are mixed in the near term. The aggressive liquidity support in the Euro zone and improvement in economic data from the US send positive vibes. But, short/medium term outlook continues to remain weak and uncertain. So, do not see great off-shore interest in the domestic equity market in the short/medium term. The bearish set up in rupee would put FIIs in wait-and-watch mode. The domestic cues are also mixed taking into account growth pressures and release of firm grip on the tight monetary policy. Given these conflicts in play, let us continue to look for consolidation at 4650-5150. The risk is for test/break of 4650 if RBI decides not to deliver CRR cut; resultant liquidity squeeze in the thin (and illiquid) December market will get the focus back to 4350-4250. For the week, let us watch consolidation at 4650-5050 with test/break either way difficult to sustain as I do not expect RBI to disappoint the market on 16th December.
Have a great week ahead..........................Moses Harding
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