Dr Raghuram Rajan’s accelerated dovishness took the market by surprise, though we must say, offshore swap market was punting on a similar outcome. Yes, governor has gambled by reducing repo rate to 6:75% and maintaining a dovish future glide path, but it is not a blind gamble. He has provided a framework in this policy that allows us to peer into his mind. He harped on using 1-year Treasury and then 1-year forward inflation outlook to compute the real rate corridor. RBI has repeatedly emphasised on a corridor of 150-200 bps. Additionally, he has also said that generally 1-yr Treasury yields trade at a 25 bps premium to repo.
Now, 1-year forward inflation expectation are at @5-5.5% and 1-year treasury at 7.00% and repo at 6.75%. For the future, RBI has kept a 50 bps discretionary corridor in the real rates, which means in repo rates too. That in our opinion will be driven by evolving global/domestic economic outlook. RBI has talked about risk of significant global economic slowdown. A very weak global economy can exert a deflationary impact on India as well. Since last year, NDF or the offshore OIS market has front-run RBI pretty well. Interestingly, I have seen forward OIS rates move more or less in tandem with global oil prices. World oil prices can be now taken as a proxy for world economic outlook, EM stress and financial system’s health. Hence, keep an eye on that. As long as that is not breaking down to even lower levels, RBI could be reaching the fag end of the current rate cycle, notwithstanding the real rate corridor which offers him 25-50 bps of discretionary power. However, if oil prices do break down further, from current consolidation, it may mean larger cuts in rates may occur.
RBI has also announced some regulatory changes:
1) RBI has suggested a framework to reduce limits on SLR and HTM bonds
2) RBI has allowed increase of FPI limits in domestic sovg. debt market in phases upto 5% by March 2018. Till March of next year, around USD 2.5 billion of fresh limits could be available to FPIs to invest in. They have been permitted to buy SDL bonds as well. All in all around Rs 1,700 crore or between USD 24-26 billion of fresh limit would be available over the next 30 months
3) RBI has allowed more participation in the when-issued GOIsec market
4) Short selling of GoIsecs by primary members has been allowed
5) RBI has allowed futures and options on majors to launched on the currency derivatives exchanges viz., EUR/USD, GBP/USD, USD/JPY
6) Now hedgers can hedge upto USD 1 million on OTC without documentation
7) They have talked about allowed institutional speculators in the OTC FX market
8) RBI has indicated that risk- weights on low-ticket housing loans can be lowered
9) Convergence of Indian accounting standard with IFRS.
All in all, we continue to believe that sovereign bonds and high rated paper can do pretty well, as both, inflation risk and default risk, nonexistent.
Turning our attention to global economy, we find US jobs data an important release. US monthly jobs data (NFP) continues on its path of downward trend, in line with other regional Fed’s economic surveys. However, the gap between surveys and NFP still remains wide on an absolute basis (refer to the chart above).In the comings months and quarters unless the economic situation improves, risk of a near zero NFP remains.
Since end 2013, there has been rising dissonance in monetary policies across major central banks. Result, has been massive uncorrelated shifts in major asset prices and economic growth rates. This dissonance is not much covered as per its importance. This has caused the world financial markets (economies) to shift from a long phase of low volatility to now a long phase of rising volatility. The G8 central bankers are now in a pickle. If ECB and BoJ announce fresh monetary policy easing, their currencies will plunge. Europe and Japan are major markets for Chinese products and also competitor in many aspects in global exports. A weaker Euro and yen hurts China, causing the Dragon to follow suit with its own version of devaluation. Asian and other EMs have little choice but retaliate and devalue. FX war intensifies, causing further steps towards trade protectionism.
If US central bank eases (more QE or better, helicopter money), then it helps all EMs, including China- a Goldilocks scenario. But US Fed does not want to climb down from its pedestal of the narrative it has created, ie, “ us economy is strong, so we want to hike rates”. It does not want to reverse course and hurt its credibility. Yellen is an extremely risk averse and copy book central banker. She may fear, that now reversing stance, from tightening to easing, may cause more harm, as the dominant narrative will be challenged. The pickle that central bankers find themselves is quite interesting and is going to provide interesting opportunities in currency and fixed income space. Pro-volatility speculators may find this constellation of forces to their advantage.
Over the near term, we can see Rupee strengthening on the back of dose of monetary policy medicine from RBI. Over the past many months, Global hedge funds could be using Rupee as a speculative long side bet against other EM currencies. So a typical trade would entail buy Rupee through forward contracts on NDF and short some other Asian or EM currency. As a result, Rupee has become a de-facto safe haven bet. Being such an instrument, can have its share of positives and negatives. On one hand, it offers central bank the stability it craves for in the currency and also allows it to mop up FX reserves. However, on the other hand, it makes Rupee appreciate against its peer EM currencies, exerting further pain on exporters, who are already reeling under weak demand conditions in the global economy.
Technically, USD/INR can go on to touch 64.80/65.00 levels on spot. Incase of a break down below 64.80, the range can expand on the downside towards 64.00/64.30 levels. However, there is a strong possibility that central bank buying may emerge closer to 65.00 handle, to prevent Rupee from strengthening too much against its peer currencies. Incase, RBI support emerges closer to 64.80/65.00, we can look at a range of 65.00-66.00 over the near term.
Anindya Banerjee is an analyst at Kotak Securities