Weekly report for 26-30 November 2012

MARKET PULSE: Weekly report for 26-30 November 2012

Political resistance to reforms is big risk factor for the Indian economy and asset markets

There is little optimism at the start of winter session of the Parliament. There is strong resistance to financial reforms cleared by the Government which was expected to sail through smoothly. It is possible that at the end, these bills will go through but the concern will be on the future. The ability of the Government to push other financial and non-financial reforms is in serious doubt. The bottom-line is that conflicts in growth-inflation dynamics is there to stay for extended period of time and the system may need to stay with elevated twin deficits. Given these strong forces in play, shift into growth supportive monetary policy may be delayed. At this stage, external cues stay favourable on hope of revival in growth, downtrend in inflation and shift into favourable monetary policy stance. This favourable tailwind may turn reverse in the absence of political consensus on reforms which will open up risk of downgrade in sovereign rating. The system is at very critical stage in a make-or-break situation and the trigger will be from the outcome from the Parliament. Over all, the future (and well being) of the Indian economy and its asset markets is in the hands of political opposition and the ability of the ruling UPA to reach consensus on economic reforms. There is no clarity on the way forward but the journey is expected to be rough and tough. The asset markets are already weak. 10Y Bond yield is up from above 8.10% into 8.25%; Rupee is down from 51.35 to 55.60 and NIFTY down from below 5830 to above 5580. The bullish expectation on the economy (and its markets) since mid September into October Monetary policy ahead of winter session of Parliament is diluted now with risk of reversal into bearish set up into the future. While Indian assets are seen to be under-valued at current levels, it is not clear whether the worst is yet to come! The financial world (and global investors) considers political risk as major hurdle for its appetite for India and it is high time for UPA and NDA to get this risk factor out of the mind for the well-being of Mother India and revival of Indian economy. The Prime Minister has already pleaded to the Opposition not to punish the country and it would be politically incorrect for the Opposition NDA to stay stubborn to place “self-interest” ahead of “pride of the country”. Let us see how things unfold. What is the impact on Indian asset markets?

Currency market

Rupee has already unwound most of its September/October rally from 56.03 to 51.35 to hit a low of 55.60 before weekly close at 55.54. Rupee would have hit 56.03 (and into historic low of 57.32) but for dollar supplies from RBI and sharp reversal in USD Index from below 81.50 to above 80. The demand for dollars in the off-shore market has stepped up bearish momentum on rupee; 3M NDF dollars which was trading at discount of 20-30 paisa (to domestic OTC/ETF) is now trading at par/premium; i.e., 3M forward premium in NDF market which was at 4.0-4.5% (as against 6.5-7.0% in domestic OTC/ETF) is now at 6.0-6.25% aligning with domestic OTC/ETF. It is seen that while off-shore investors have greater comfort on investments in bonds and equity market, they are seen to hedge resultant exchange rate risk in the NDF market. This risk factor was highlighted in MARKET PULISE looking for outperformance of NIFTY over rupee exchange rate. Since disappointment in October Monetary policy, MARKET PULSE urged importers to stay covered on short term imports. In the intra-week update on the Twitter, it was considered 55.60-56.10 as worst case for rupee and urged importers to unwind short term import cover and exporters to start hedging 12M receivables with the strategy to reinstate import hedge on pull-back into 54.60 or break of 56.20. USD/INR traded high of 55.60 on spot and 58.60 on 12M. What next? Rupee will be under pressure till political risk is out of the way. During this time, rupee’s traction with Euro gains will be diluted while pressure on rupee will be more on reversal in Euro gains; dollar supplies in the forward market will be cut. It will be dollar demand driven mode in the cash/spot market with importers in a hurry to hedge short term imports. Having said these, 12M forward dollars at current level looks good for exporters to cover long term receivables; forward value of 58-60 is seen good to cover long term exports in phases given the expectation of long term spot rupee range at 45-60. For the week, let us watch consolidation at 55.10-55.60; break here will open up swift extension into 54.80-54.60 or 55.90-56.10 for near term consolidation at 54.60-56.10. Rupee weakness into 55.60-56.10 will be stretched and would look for strong arm tactics from RBI and the Government to protect this zone to prevent its adverse impact on the Equity and Bond market. The strategy is not to stay long dollars at 55.60-56.10 and would be prudent to cover short term imports at 55.10-54.60. At this stage, would stay neutral on break-out of 54.60 or 56.10; extended weakness beyond 56.03 into 57.32 will bring gloom and doom on the Indian economy and its asset markets. There is immediate need to establish rupee stability (with bullish undertone) till issues related to trade (and current) account deficit is addressed.

USD Index failed at set reversal point of 81.35-81.50 (high at 81.45) to meet its first objective above 80 (low of 80.13) after pass through of strong support at 80.70-80.85. This drove Euro up from lower end to higher end of set 1.2665-1.2915 range. In the intra-week update on the Twitter, we revised the range into 1.2825-1.3175 with immediate objective at 1.30. Since then, Euro has rallied by over 300 pips from 1.2660 to 1.2991. What next? USD Index is set for extended weakness into 79.60 ahead of 79.10-78.60. In the meanwhile, Euro is expected to extend its rally into 1.3140-1.3170 to complete 500 pip rally from 1.2660. It is good for exporters to hedge long term Euro receivables at 1.3140-1.3170, keeping room for adding below 1.34. Euro is set to get into consolidation mode at 1.29-1.34 into the immediate term. For the week, let us watch 1.2915-1.3140 with extension limited to 1.2865-1.3190. The strategy is to hold on to long Euros with trail stop below 1.2915 for 1.3140-1.3190 and switch sides here with tight stop on break above 1.3215 (for reinstatement of longs at 1.2915-1.2865 for 1.3365-1.3390).  

USD/JPY got into consolidation mode after completion of over 350 pip rally from 79.06 to 82.82. We did not wish to chase gains into 82.65-82.90 where we asked to unwind longs and stay short for correction into 82.15-81.65 before up into 83.25. What next? No change in view as we look for consolidation at 82.15-82.75 with extension limited to 81.65-83.25. The near term outlook is for consolidation at 81.75-84.25; while the bias is up, break either-way difficult to sustain.

Interest rate market

10Y Bond has traded back-and-forth between 8.10-8.25% range; fell from 8.23 into 8.11% on run into October Monetary policy; post no rate cut stance of RBI and worries on reforms, yield is now up from 8.11 to 8.23%. OIS rates have tracked bond yield trading back-and-forth between 7.55-7.80% (1Y) and 7.0-7.20% (5Y) and now at the higher end. What next? Cues are mixed on interest rate direction with risk of slippage in fiscal deficit above 5.8% and strong downward pressure on GDP growth below 5.5%. RBI also cannot afford to cut policy rates when rupee exchange rate is under pressure. Here again, political risk (on reforms) comes in the way for RBI to deliver rate cut on or before January 2013 Quarterly review of monetary policy; need to stay neutral on rate cut till financial reform bills are through in the Parliament. On the other hand, system liquidity is comfortable despite over Rs.1 Trillion draw-down from Repo counter with excess SLR holding estimated to be at over 4% NDTL (over Rs.2.5 Trillion). This “gap” is either funded in the CBLO market or out of deposits. The monetary policy action in the near term may be through aggressive OMO Bond purchases. Taking all these together, 10Y Bond yield should stay below 8.25%; so are OIS rates below 7.80% in 1Y and 7.20% in 5Y; trigger of political risk  on the economy will drive bond yields and OIS rates up which we don’t bring into the radar now. For now, we will continue to track 10Y Bond yield at 8.18-8.25%; 1Y OIS rate at 7.72-7.80% and 5Y OIS rate at 7.12-7.20%. While we stay neutral on break-out direction, will not prefer to stay “short” at/above 8.23-8.25% (10Y Bond); 7.78-7.80% (1Y OIS) and 7.18-7.20% (5Y OIS) where risk-reward (for staying short) does not look favourable at this stage. Strategic investors who have traded end-to-end of said short term range can stay invested at these levels with tight stop on conclusive break of set higher ends.

FX premium was driven largely by exchange rate play with very little play from interest rate. The volatility in exchange rate from 56.03 to 51.35 to 55.60 provided back-and-forth move between 6.15-7.15% (3M) and 5.35-6.15% (12M) and is now at the lower end tracking bearish set up on rupee. What next? Given the firm interest rate outlook in the near term and seeing 55.60-56.10 as worst case for rupee, MARKET PULSE advised to unwind received book at 6.15-6.0% (3M) and 5.40-5.25% (12M) and switch sides there to open up “paid book”. For now, we watch 6.0-6.5% in 3M and 5.35-5.60% in 12M; bias is for test/break of higher end in the immediate term. The strategy is to retain the “paid book” (enjoying decent carry of 7.5%); will exit paid book on rupee weakness beyond 56.10 or spot rupee gains into 54.60.

Equity market

NIFTY traded in consolidation mode between sell zone of 5640-5670 (high of 5643) and strong support at 5580-5530 (low of 5549) before comfortable weekly close at 5626. Despite strong bearish set up on Bond and Rupee exchange market, NIFTY held well on FII support and increase in investment limit for LIC, largest domestic institutional investor in the market. What next? There are no strong bullish cues at this stage. There is risk of withdrawal of FII support for equity market. If the investors have to choose from Fixed Income and Equity assets, there is good chance of double-digit return in Bonds and significant downside risks in equity assets. There are lot of risk factors in play such as political consensus on reforms, sovereign rating downgrade, slippage in growth, overshoot in fiscal deficit, elevated trade deficit, high dependence on external liquidity, elevated inflation, possible delay in shift into growth supportive monetary stance etc. For now, we will watch 5550-5670 and stay neutral on break-out direction; break either-way will be good for 150 points either into 5400 or 5820. The strategy is to trade end-to-end of 5550-5670 with stop/double reverse for 5400 or 5820. Strategic investor can look to reinstate investment by buying the first lot (of the three) at 5580-5550 and watch momentum around 5670.

Commodity market

Gold has now completed the first round of rally from 1705-1690 into 1750-1765 (high of 1754) and looks good for extension into 1790-1805 in the immediate term while 1735-1720 stays firm. The demand for Gold is there to stay into near/short term with medium term objective for revisit to recent high of 1920. For now, we watch 1735-1790 with extension limited to 1720-1805 with bias into higher end. The strategy is to hold to “long” position with trail stop below 1735 for 1790.

NYMEX Crude traded end-to-end of 85-90; up from 85.02 to 89.80; down into 86.17 before close of week at 88.28. The moves were driven by sharp reversal in USD Index and news out of West Asia. The cues for the immediate term are mixed; weak dollar should provide support while resolutions in the West Asia crisis will exert downward pressure. For now, will continue to watch strong resistance at 89.50-90.00 while 86.50-85.00 staying firm. The near term outlook is mixed either for shift into 88-93 consolidation or revert to bearish trend into 82.50-80.0. It will be good risk-reward to sell in two lots at 89.50-90.0 and 92.50-93.0 with tight stop for 82.50-77.50.

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