20th May 2014

INR: Modi looks to have done it comfortably

The Financial Times reported that the Congress Party conceded defeat in the early hours of Friday morning following indications that Modi’s BJP party had achieved a landslide majority. Subsequent headlines on Bloomberg suggest that a Modi led alliance is leading in 302 seats (30 more than is needed for an outright majority). As Friday progressed, the news became even more positive for Modi as it looked increasingly likely that his party would achieve a majority on its own. This seemed to be confirmed over the weekend with news flow suggesting Modi’s party had achieved 272 seats. When his traditional allies are included, news reports suggest he will hold 339 out of the 543 seats.

The market responded very positively to the news. In an otherwise downbeat session, the Sensex smashed through the psychological 25,000 level to reach a record high of 25,322 and USDINR traded to a 10 month low of 58.69. This was very close to our long standing prediction that USDINR would trade down to 58 on a good election result. Profit taking caused both to backtrack a little during the remainder of Friday’s session. For USDINR, Bloomberg also reported that the RBI’s purchase of USDs has been another notable headwind – in line with our other prediction that the RBI would use INR rallies to increase its FX reserves.

We think this news has the potential to be a game changer for India. After multiple decades of weak governments and worries about corruption, India looks set to be ruled by a single party government. This is the strongest position Modi could have wished for and we believe gives him the best chance of delivering India’s much needed reforms. When this is added to India’s great demographics, a central bank that is finally getting to grips with inflation, a cheap currency and a much better external position, it is hard not to be more optimistic about India’s future. We think this will help encourage additional equity and FDI flows into India
and potentially help USDINR break through 58 in the next few months.

We think the INR is unlikely to reap the full benefits of today’s news over the next year. The RBI has been vociferous in its desire for a stable currency and its rapid accumulation of FX reserves this year is a clear indication of its intentions. We think this consistent headwind will encourage the market to be quick to take profits and restrict the INR’s ability to rally on good news.

The next 12 months are also unlikely to be devoid of USD positive bumps. For example, India’s policy makers could disappoint, poor weather could play havoc with India’s onion price inflation and other central banks could get their communication policy wrong (remember the taper tantrum) or even hike rates (G4 central banks used to do that!). India’s much improved outlook should limit the size and length of pullbacks. In particular we think it is very unlikely that USDINR comes close to returning to last year’s 68.85 high. Nonetheless, we do think India’s improved position will be insufficient to make it fully immune from EM wobbles/USD strength. We continue to forecast USDINR at 60 in 1 year.

EUR: No news to point the needle away from looser policy

We believe the euro area news last week is consistent with the ECB loosening policy at its June meeting.
• Current inflation is still low: The clear message from May’s ECB meeting was that the committee is “unanimous in its commitment” to deal with the risk of a “too prolonged” period of low inflation. At the time of the May meeting preliminary data suggested that INCLUDING, a bounce back in prices from the Easter effect, y/y price growth to April was 0.7%. Today’s final estimate for euro area inflation April confirms this modest reading – giving no reason for the ECB to change their stance. In fact, at the margin, the inflation picture has deteriorated with French and Italian CPIs printing below expectations this week.

• Growth numbers also disappointed in Q1: The ECB is mandated to keep inflation anchored at 2% over the medium term (2 years). This target allows the ECB to look through low inflation if they believe growth will pick up, the output gap will close and inflation rise. Today’s data shows the euro area only grew by 0.2% in Q1 versus the 0.4% expected. When broken down by country the particular concern was the 0.1% contraction seen in Italy. This news provides no comfort to an ECB already worried about low inflation risks.

• Professional forecasts for inflation tweaked lower to 0.9% for 2014, 1.3% for 2015, 1.5% for 2016 and 1.84% for 2018. As these forecasts are close to the ECB’s staff forecasts from March they are no reason for alarm. Nonetheless, they too give no new comfort to the ECB.

Since Draghi alerted the market to the possibility of looser policy, the market has started to price in some action causing the refi rate to fall from around 22bps to 17bps. As interest rates matter for currencies, this fall has helped drag the EUR lower. This suggests the ECB will need to do more than just cut the refi rate to around 15bps (as many market commentators expect) if the EUR is to come under more pressure. We think the “more” will consist of dovish language and a cut in the deposit rate. If so, we think EURUSD could trade down towards 1.35.

In our opinion, EURUSD is unlikely to fall much below 1.35 unless the ECB does something to aggressively reverse its shrinking balance sheet and/or US 10y yields break above 3%. We think there is some possibility that the ECB announces its intention to stops its drain of liquidity created by the Securities Market Programme (SMP) at the June meeting. However, we believe this would slow the speed at which the ECB’s balance sheet shrinks rather than increase it. We think there remains too much political resistance to launch a quantitative easing programme (which would dramatically increase the size of the balance sheet) and that US yields are unlikely to move substantially higher until Q4 2014. We continue to forecast EURUSD at 1.33 in 1 year.

The currency we expect to move down by more than the EUR is the CHF. For now, the EUR and CHF are largely moving together against the USD. This is because the 1.20 floor in EURCHF prevents the EUR from falling much quicker than the CHF. As EURUSD falls towards our 1y target, we believe European assets will look more attractive to foreign buyers. We think this increased inflow will help EURUSD stabilise around 1.33. However, we think this same inflow will help the EUR move higher against the CHF. This suggests that while EURUSD moves sideways around 1.33, USDCHF could continue to appreciate. As such, we see a great potential return from being long the USD versus the CHF than the EUR.
Weekly currency


#   #   #