Rupee set to rally as Indian equities play catch-up

The RBI cut reserve requirements by 50 basis points to 5.5% in January, but left other policy rates on hold. With easing domestic inflation pressures, many believe the central bank will ease monetary conditions further at its policy meeting on March 15 and implement more cuts throughout the year, just as it did in 2008-2009 to boost its economy.

Indeed, the Bloomberg consensus is 100bp of cuts in the RBI’s main policy rate throughout 2012.

For the rupee, this is not necessarily an impediment to further gains.

That is because the rupee is essentially a current account deficit currency that does well during periods of rising risk appetite and poorly during time of panic, such as that witnessed in the second half of last year.

Foreign inflows into equities are the main swing factor for the currency, given government controls on foreign ownership of local currency bonds.

Credit Suisse (CS) has lowered its three-month USDINR target to Re48.00.

“Given the ongoing strength of the US economy and Europe pushing Greek funding problems, we think that the risk appetite background for inflows into Indian equities is good,” says Aditya Bagaria, strategist at CS.

He cites the improving balance between Indian growth and inflation, which has historically implied robust equity returns. Also, Bagaria notes that, even after the rally in Indian stocks seen so far this year, equities have still undershot earnings levels.

The risk to this view is that oil prices continue to rise. That is not because of a rise in crude prices per se – the rupee is surprisingly uncorrelated with the price of oil – but because of the potential effect of surging oil prices on broader risk appetite.

In the short term, however, the RBI should offer some protection from this risk, given the central bank’s aversion to USDINR trading too far above Re50 and its recent willingness to intervene to strengthen the rupee.

Bagaria recommends using options to position for strength in the rupee against the dollar.

He says despite the decline in implied vols since the start of the year, front-end USDINR vols are still above the lows from early in the fourth quarter and continue to look rich relative to delivered vols based on daily fixings.

“Even though USDINR risk reversals remain skewed to the topside, they have cheapened in line with the sell-off in spot and implied vols,” says Bagaria.

“This leads us to favour put butterflies and leveraged put spreads with a short gamma bias to position for further near-term appreciation of the rupee versus the dollar.”

To express a more medium-term bullish view on the rupee, CS believes that selling outright USDINR risk reversals in the back-end looks attractive.

“Despite the cheapening in front-end risk reversals, long-end risk reversals remain very elevated, especially on a vol-adjusted basis,” says Bagaria.