Bullish undertone in Bond market against complex macroeconomic dynamics
Bond market has been in bullish undertone since August-November 2012 in anticipation of shift in RBI’s monetary policy stone from hawkish to dovish; it is felt necessary and over-due as hawkish stance is seen as bit stretched since March 2009. 10Y Bond yield is already down from the high of 8.28% since August 2012 (and 8.24% since November 2012) to 7.85% providing annualised return of over 18% on August 2012 investments (over 30% on November 2012 investments). Given this kind of attractive return against sovereign risk (without capital charge), huge build up of 7% excess-SLR is not a surprise when credit risk is not at attractive premium! During this time, Bond Swap spread (funding Bonds from CBLO/Repo counter with OIS hedge for similar maturity) is down from 1.2% to current 0.65% (driven by sharp fall in Bond yield from 8.28 to 7.85% and marginal spike in 5Y OIS rate from 7.0% to 7.20%). MARKET PULSE urged in August-November reports to lock-in to the high spreads (by staying “long bonds” with “paid 5Y OIS” for sharp reversal into short term that would cover both price appreciation on the Bonds and positive “carry” on the OIS book against high overnight MIBOR. What next? Is it the time to unwind or run the profit?
Bond yields (at current level) has already factored in 25 bps rate cut (shift in operating policy rate from 8% to 7.75%) while 50 bps rate cut (driving the operating policy rate to 7.5%) will extend the bull-run to drive 10Y Bond yield into 7.65% (cutting the Bond Swap spread to 45 bps). This is seen as the best case scenario into short/medium term. There are strong risk factors on the way. The excess SLR holding is already to the tune of Rs.4.5-5.0 Trillion, which is 1 year of market borrowing. The task for RBI will be a tough balancing act to retain the demand appetite intact and divert funds from sovereign credit to corporate (and productive) credit. On the other hand, macroeconomic dynamics are complex. The pressures on fiscal deficit, Current Account deficit and Rupee exchange rate are highly inflationary. But without sharp turnaround in Growth momentum (leading to higher revenues), making both ends meet will be difficult given the huge burden from high interest cost, huge subsidy cost and elevated administrative cost. It may not be easy to bridge the huge gap in Trade Account (at over $18 Billion a month) through sustainable flows from remittances and Capital account flows. Over all, concerns on twin-deficits (and resultant impact on exchange rate) are there to stay for long; there seems to be strong “will” to get out of this vicious cycle but concrete “ways” are not seen to be at sight. Given these strong headwinds in force against twin-deficits and inflation, RBI’s ability to shift into aggressive growth-supportive monetary stance (like prevalent in Western and emerging economies) is in doubt. So, at best it would be limited monetary support (to growth) in the near/short term and extension of support into medium/long term will be dependent on significant improvement in fiscal deficit (into 4.5-5.0% of GDP), current account deficit (into 3.0-3.5% of GDP) and headline WPI inflation (into 6.0-6.5%). It is also seen that despite tight system liquidity and elevated interest rates, domestic consumption is good. The worry however is on the investments which would be driven by turnaround in macroeconomic dynamics and not through dovish monetary stance. Taking all these factors, operating policy rate is not expected to ease below 7.5% in the short term (till September 2013). This expectation sets up strong base for 10Y Bond yield at 7.65% with pressure into 7.80-7.90% and beyond to cover pipe-line bond supplies, and RBI would need to shift gear on its OMO bond purchases to cut build up excess SLR to over 10%. The trading range in the short term is seen at 7.65-7.90%; range break-out if any will be on the higher side into 8.0-8.10% on deterioration in macroeconomic fundamentals bringing the risk of sovereign rating downgrade into play. The strategy therefore is to “unwind” investments at 7.65-7.80% (Bond swap spread at 45-60 bps); need to retain good “appetite” to absorb weakness into 7.90-8.10% during H1/FY2014.
Interest rate market
The trading range for 10Y Bond will be set post the headline WPI data release on 14th January (Monday, at start of the week). The guidance (for rate cut action) will be from print of December 2012 number at lower end of 7.0-7.5% tolerance zone and revised November 2012 number staying below 7.5%; disappointment on either of these may delay rate cut action while both the number into the lower end will trigger expectation of one-shot 50 bps rate cut on 29th January. There are three options on hand: bullish extension into 7.65-7.80% on good data print (building 50 bps rate cut); sharp reversal into 7.90-8.05% on weak data (unwinding build-up of 25 bps rate cut expectation) and consolidation at 7.80-7.95% on neutral data print (lack of clarity on RBI’s rate action with fear of delay in rate cut action). While there is little confidence on getting a strong number (which would be a very pleasant surprise), it would be a toss-up between neutral and weak data (at 7.25-7.5% for December 2012), thus setting up a wide trading range at 7.80-8.05% post data release. Fingers crossed!
It was extension of 1X5 play in OIS rates; 1Y OIS rate is down from recent high of 7.68% to 7.53% while 5Y rate is up from recent low of 7.08% to 7.20% (1X5 discount down from over 60 bps to below 45 bps building steepness in the tenor curve). Taking the above-said three options on hand, the best case for 1Y OIS rate is seen at 7.45% with worst case at 7.70% while neutral stance will provide consolidation at 7.50-7.60% (preferred scenario). 5Y OIS rate will stay bid but upside is seen limited on trigger of unwinding of Bond Swap trades. The trading range for the week is seen at 7.50-7.60% (1Y) and 7.13/7.15-7.23/7.25% (5Y). The strategy is to trade end-to-end as break either-way is not expected to sustain.
FX premium tracked exchanged rate moves, down initially into 6.6% (3M) and 5.6% (12M) on start-of-the week rupee weakness into 55.38 but recovered sharply into 7.1% (3M) and 6.1% (12M) on rupee strength from 55.38 to 54.40. Over all, FX premium is boxed in consolidation mode within set near term ranges of 6.60-7.1% (3M) and 5.60-6.1% (12M). Interest rate play is now neutral factoring in 25-50 bps rate cut and break-out of this range is dependent on break-out of spot rupee range from 54.35-55.35. Given the higher possibility of break-up in spot USD/INR (very low probability of break-down below 54.35-54.10), it is not prudent to stay “paid” above 7.1% in 3M and 6.1% in 12M. For the week, let us continue to track 6.60-7.1% (3M) and 5.60-6.1% (12M) with bias into lower end. The strategy is to trade end-to-end as there are no strong cues to suggest break-out either-way.
Currency market
USD/INR traded to the script trading end-to-end of 54.35-55.35 range (initial high at 55.38, sharply down at 54.39 before close of week at 54.76); in the process triggered first “sell” at 55.35 and “buy” levels at 54.65/54.40. The forward dollar moved end-to-end within the set trading range for 3M at 55.25/55.50-56.25/56.50 (high at 56.30; low at 55.35 before close at 55.72) and for 12M at 57.60/57.75-58.50/58.65 (high at 58.53; low at 57.66 before close of week at 58.02). What next? The undertone of rupee is weak driven largely by the concerns on widening (and highly elevated) trade/current account deficit and lack of confidence on sustainability of FII’s appetite on over-valued Indian equity market. Over all, despite solid support from external cues (availability of sufficient liquidity to emerging markets and bullish Euro against US Dollar), domestic cues are fragile, suspect, weak and vulnerable to huge downside risks with limited upside gains. Taking all these fundamental factors into play, MARKET PULSE preferred short term range trade for USD/INR at 54-56 till February/March 2013 and await fresh cues (post Budget FY14) to take a firm view on range break-out. RBI (and the Finance Ministry) should be concerned with this strong bearish set up on rupee with Rupee seen as the worst performing currency! Rupee unable to get the benefit of USD weakness (against global currencies) while over-reacting to USD strength is serious worry for the rupee bulls (who are seen to have given up!). However, need to take note of Governments’ aggressive stance to address fiscal consolidation to get RBI into growth supportive monetary stance to revive growth momentum. For the week, let us watch consolidation in USD/INR at 54.10/54.35-55.10/55.35 (3M at 55.10/55.30-56.10/56.30 and 12M at 57.40/57.60-58.30/58.50). Strategic players can trade end-to-end by selling in 3 lots at 54.85/55.10/55.35 and buy in 3 lots at 54.60/54.35/54.10 with tight stop. We will review (and reassess the strategy) when 54.10-55.35 range break-out comes into focus while staying with 54.10-55.60/56.10 short term range.
EUR/USD rallied sharply from 1.2990-1.3015 support (recent low at 1.2997) into 1.3350 (high at 1.3365) before close of week at 1.3341. MARKET PULSE considered 1.3150 as strong intra-2013 support driven by strong interest rate play in favour of the Euro. The expectation of 25 bps rate cut triggered the sell-off below 1.3150 but no-change stance of ECB on policy rates (with hawkish stance on the way forward) brought the bullish Euro undertone back into play. What next? Euro should extend its bullish move into 1.3485/1.3550 while 1.3310-1.3250 stays firm. 1.3250 is very critical to stay intact to prevent revisit below 1.3150 into 1.3000. For the week, let us watch 1.3260/1.3310-1.3490/1.3540; bias is for move into higher end and thereafter prepare momentum for bullish extension into 1.3800-1.3850.
USD/JPY held at strong support/buy zone of 86.75-87.25 (low of 86.81) and extended its bullish run into 90 (high so far at 89.44) before close of week at 89.17. The focus now is at May 2010 high at 94.98 while 88.00-88.50 stays firm. Over all, USD/JPY has shifted into higher range trade at 88-91 with bias into higher end. For the week, let us watch 88.40/88.80-90.50/91.00 with bias into higher end.
Equity market
NIFTY traded end-to-end of set weekly range of 5940-6040 (high at 6042 and low at 5940) before close of week at 5951. The cues into near term are mixed. There is investor appetite in anticipation of cut in policy rates and deriving bit of comfort from the Government to get the growth momentum back on track. It is also believed that worst is behind (on macroeconomic fundamentals) and build up of strong base is work-in-process for gradual recovery into short/medium term. So, there is no need to get bearish at this stage. On the other hand, excessive gain seen in 2012 is being unwound; hence unable to extend gains beyond 6040. It is possible that NIFTY is into near term consolidation mode at 5800-6100. For the week, let us watch consolidation at 5880/5910-5980/6010 and stay neutral on further extension into 5850-6040. The directional bias will be set post release of headline WPI inflation number but test/break either-way is not expected to sustain.
Commodity market
Gold is in consolidation mode at 1625/1640-1680/1695 (with intra-week low of 1642 and high of 1678) before close of week at 1662. The undertone is mildly bullish into higher end driven by weak US Dollar. No change in view and we continue to watch consolidation at 1640-1680 with extension limited to 1625-1695. The strategy is to trade end-to-end and there are no strong cues to trigger break-out either-way.
The rally in NYMEX Crude from 85 (low at 85.21) has extended into 95 (high at 94.70) unwinding most of sharp reversal from 100.42 into 84.05. The undertone is neutral to mildly bullish and seen to be shifted into higher range trade at 92-97 with bias into higher end. The strategy is to trade end-to-end and there are no strong cues to trigger break-out either-way.
Have a great week ahead............................Moses Harding
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