INR 1Y forward view: headed lower?

Inflation and Interest rate view

·        High interest rates are required to control inflation. High real interest rates control demand and encourage people to save, thereby pushing inflation even lower.

·        The June 2017 RBI’s consumer confidence report indicates decreasing confidence that consumers have in their income growth and job opportunities. This coupled with high real rates should affect demand negatively as people save more.

·        GST in the short term can affect business and therefore spending confidence adversely.

·        Demonetization would affect consumer spending as the propensity to spend cash is much more than to spend tax paid money through cheque. Tax paid money is generally saved in FDs and equities.

·        For the next 8 months, India’s inflation should average 3% ((1.5+4.5)/2), therefore according to the current interest rate, for remaining FY18 India’s real interest rate would be 6-3=3%. Which is one of the highest in the world if not the highest. RBI a couple of years back has stated that 1.5-2% was its target for real interest rates. 

·        Such high real interest rate medicine, should ensure that inflation undershoots the forecasts in spite of the base effects and technical HRA adjustments, as demand could remain subdued. In fact a lower real interest rate could be required at CPI significantly below 4% pivot to boost demand.

·        Below target global inflation also points to this reality.

·        Appreciated INR keeps imported inflation and internationally benchmarked prices in check as well.

·        Therefore I would expect lower inflation readings and markets subsequently pricing in 1 more 25bps rate cut during the current FY.

USDINR 1Y forward view

o   Below chart shows India and US inflation differential vis a vis INR 1 Y forwads

o   In the last 1 year, although India’s inflation has surprised on the downside forwards have not been able to move significantly lower, except for the period of Nov 2016 when RBI stopped paying forwards as it neared the FCNRB repayments (chart below)

o   Current 1y forwards are at 4.3% while interest rate differential is at 5%. During period of INR appreciation (like the current one) forward rates have been 1.5-2% below interest rate differential. Looks like in June 2017 RBI has also allowed forwards to move lower as it cut rates.  

o   Going forward if RBI does not want INR to appreciate too much then it would want lower forwards. Higher forwards make carry trades more attractive and encourage speculative short USDINR positions, compounding RBI’s rupee and liquidity problems.

o   US is expected to raise rates once more in 2017 and once in 2018.

o   Given the India inflation view and the past behaviour of the forwards along with RBI’s reservation with significant INR appreciation, the following is what I would expect on USDINR 1 year forwards

·        Receive 1 year forward  at 280p or at 4.45% for a move to 3.5% pa or 223p at current spot. 248p could act as a strong support. Stop would be a weekly close above 295p (which would be a reversal of the June 2017 post rate cut move). CMP 275p.