Financial markets proposed but Reserve Bank of India (RBI) Governor Raghuram Rajan disposed, but that did not deter the participants from continuing to bet their money on the view that interest rates in India are on a downhill path.

In fact, in the West it has been widely debated in the past as to whether it is the central bank that sets the course for interest rates in the economy or is it the visible hand of market that persuade central banks to follow a pre-set course. Back home in India, RBI maintains a tight leash on the domestic rates market, both at the shorter end, where it enjoys a complete control, as well as at the longer end.

There are tools available to the market participants to express their view on the rates. There is the short to medium term OIS market, the MIFOR up to 1 year is traded and now even the offshore OIS and MIFOR rates up to a year are available.

Ultimately, interest rates are the price of funds in the economy and just like any other price of goods and service, it is largely determined by the forces of demand and supply. A central bank manages the transmission of its monetary policy by tweaking that demand and supply curve to move the interest rate towards its preferred corridor. Currently, though RBI has kept the repo rate at 8% (the rate at which banks can borrow funds against collateral for the very short term), money markets, thanks to excess flow of financial liquidity and deflationary trend in global hard asset prices, have pushed some of the signaling rates much below the repo rate. The 1 year NDF MIFOR rates are quoting around 5.60% over the spot, indicating an expected short term interest rates of sub-7% in times to come. The question then comes to mind is, would RBI allow the repo rates to fall by atleast a 100 bps over the next one year?

As long as the deflationary trend in global hard assets continue, India would not only be importing deflation but also domestic cost push price inflation would remain muted. At the same time, if the domestic economy moves in a very gradual path of acceleration, which appears likely than a hockey stick like path of improvement, then inflation expectations can fall towards RBI’s medium term target of 6% and remain there to allow for it act slash rates in a meaningful manner. However, we would like to caution that, we find a substantial shift in the path of the current governor’s approach towards monetary stability. DR. Rajan has repeatedly emphasized on the need to provide a sound monetary anchor to the Rupee value. Rupee being a fiat currency has no anchor like available to a currency backed by hard money like Gold. Hence, it becomes imperative that the central bank provides an anchor in the form of low and stable inflation. In that regard, the governor has repeatedly talked about the need for a real rates to stay positive to provide the saver with an incentive to accumulate financial assets and enable money flow in the domestic economy. Hence, for repo rates to fall to 7% or lower, inflation expectation has to remain anchored around 6% for long time, which means the reduction in interest rates might happen in a very slow manner.

Over the previous week, Rupee has been largely ranged between 61.75 and 62.15 levels on spot. The stand-off between the central bank and the foreign investors continue as the latter is looking to sell on any uptick in the pair. However, the central bank, wanting to cushion to the US Dollar to prevent exporters loosing too much of competitiveness to our peers, have been using the spot and forwards market quite effectively. We find a parallel into history, between 2004 and 2006, when relentless intervention from the central bank kept the pair within a tight range of 43 and 46:50, inspite of domestic asset markets climbing new heights.

Forward premium on the spot, which is function of the state of Rupee liquidity and future direction of interest rates movement in India and US, has eased considerably. Infact, for someone looking to hedge his or her US Dollar exposures for a year, can do that now in as low as 7.10-7.15% premium over the spot US Dollar/Rupee rate and that same transaction a foreign investor can do in the offshore trading centers at a cost as low as 5.50-5.75% premium over spot rate.

Though RBI has stayed pat on its rate on lending to banks at 8% but there seems to be a widespread belief that it is only a question of when and not if, the rates are lowered by the central bank. At the same time, central bank in its zeal to keep the volatility in the Rupee low has been intervening on both sides of the market. The resultant effect of such kind of intervention has been substantial drop in the short and medium term volatility in the Rupee. However, at the same time a strong uptrend in the US Dollar overseas has created a widespread belief that Rupee can continue to weaken at a slower pace against the US Dollar. A combination of low volatility, expectation of slow depreciation in the Rupee and lower forward premium on the US Dollar is coming as a triple whammy for the external sector players.

Our channel check has revealed that importers as well as exporters have reduced their hedging activity. For an importers, paying a premium of 35 paise on average per month on the Dollar to hedge is not exciting as volatility stays low. At the same time, exporters seeing the possibility of Rupee remaining in a path of slow depreciation is not finding the low forward premium attractive enough to hedge for the medium term. For example, if the current spot rate is around 62.00 to a Dollar and the price of a 3-month futures contract /forward contract on the US Dollar against Rupee is around 62.90 to a US Dollar and if the market participants believe that in the spot Rupee can depreciate towards 63.00 by then an exporter will be not be encouraged to hedge for a quarter. At the same time an importers or a borrower in US Dollars would not like to pay a 90 paise premium over the spot as Rupee volatility remains low. Low volatility also encourages foreign speculators to play carry trade in the Rupee, something we have discussed in our previous week’s note. All in all, it increases the future instability in the Rupee. Therefore in the future, when the market is able to fairly determine the value of Rupee, we can see a sharp move unfold in one particular direction. It has been well researched that in financial markets, periods of low volatility precedes and follows periods of high volatility. At the same time, if that volatility is artificially compressed through financial innovation and or policy tools, the resultant change in volatility in the future can be much larger and can also persist for long. We believe, we have seen enough examples of that phenomenon playing out in the financial assets and the hard assets.

In domestic economic news, RBI has maintained a status quo on rates and even on all liquidity measures. However, central bank sounded a dovish tone by indicating that the shift in monetary policy can occur in early part of the next year. In other news, in November, manufacturing activity in India rose to a 21-month high. For November, the PMI rose to 53.3 points from 51.6 points in October. . At the same time, activity in India’s services sector expanded at its fastest pace in five months, mainly driven by new order flows. The index rose to 52.6 in the month, compared with 50 in October.

In global economic news, global manufacturing sector sentiment, measured by J.P. Morgan alongwith Markit, eased to a seven-month low. At the same time, US economy added nearly 321,000 jobs over the month of November, much above the 230K-260K being expected by the market. Since 2010, November has been one of the best month for job growth in the US economy due to the pick-up in hiring that occurs into the festive season. US unemployment rate remained unchanged around 5.8% and internals of the jobs reported indicated that there has been some improvement in the structural measures of unemployment as well. However, the distribution of jobs added continues to be dominated more by low paying service sector jobs. The wage data known as average weekly earnings growth decelerated to 2.17% in November. However, in a muddle state of global economy, US alongwith UK, remain a few areas of strength.

The European Central Bank quite expectedly remained pat on its monetary policy. ECB downgraded economic forecasts and lowered inflation projection. However, apart from open ended promise he did not offer any timeline to the sovereign QE. It was not a surprise to know that ECB faces opposition within the ranks about a sovereign QE. ECB said that though opposition remains to a full blown quantitative easing program, but if inflation and growth fall sharply ECB will be compelled to act. ECB also hinted at increasing its balance sheet size by Euro 1 trillion over the next two years, through a combination of T-LTRO and covered bond and ABS purchases.

US Dollar remains the preferred currency of choice in the world due to the combination of divergent path of growth/monetary policy in the west and the rising wedge between US economic growth and growth of the Asian and EM countries. Yen remains as a source of carry funded frenzy in global equity and debt markets and that means a high correlation has formed between a collapsing Yen and a melting up global risk assets. The near vertical moves in Yen and global equity markets and debt markets have made many people question the sustainability of the same. However, we need to remember a very relevant quote from the economist John Maynard Keynes, “Markets can remain irrational longer than you can remain solvent”.

Indian Rupee is expected to remain in a path of slow depreciation against the US Dollar, hence, importers and speculators can look to buy between 61.40/75 levels on spot. At the same time, Indian Rupee will continue to be our favoured pick against the Yen and the Euro. Against the Pound, we would play a range of 95.50 and 97.50 on spot.

By Anindya Banerjee, analyst, Kotak Securities