Market’s volte-face on Fed’s future path is a risky trade

Market’s volte-face on Fed’s future path is a risky trade
Market’s volte-face on Fed’s future path is a risky trade

A presumed dovish Fed stance in the week’s testimony and the correction in crude prices have been interpreted as signs of a relapse in excess global liquidity and risk-on trade. It, however, is a false signal, as the Fed is likely to stay put on its normalisation path. The recent gains in the rupee and the softening in G-sec yields could reverse, precluding a full maturation of the risk-on trade.

Going forward, the rupee could still touch 75 a dollar and 10-year G-sec yields may rise to 8 per cent by the end of the financial year. The Nifty could move in a range of 10,400-11,000 in the 12 months, says a report by brokerage Emkay Global Financial Services.

The brokerage said it is underweight on the broader markets.

Dismissing market expectations of a return of easy liquidity conditions, the report says, “the steep 29 per cent decline in global crude prices since early Oct’18 and the concerns about US growth have suddenly shifted the consensus views back to deflationary risks, prompting increased expectations for an early end to the Fed’s rate normalisation process. This is recreating a belief that the relapse of a weak dollar and easy liquidity will propel portfolio flows to emerging markets, including India.” But there is considerable risks to trade based on such assumptions, says the report.

It says consensus expectations now price in only two or three more rate hikes until 2019-end. However, this contrasts with the Fed’s guidance of four more hikes to 3.25 per cent by 2019-end. “Our estimate for a fair value of the Fed rate is closer to 4 per cent, and we expect it to breach 3 per cent in the next 12 months.”

US solidity, it says, is in contrast with the market’s volte-face. “The concomitant occurrence of positive output gap (real GDP growth of 3.0-3.4 per cent compared with a potential 2 per cent), negative unemployment gap (unemployment rate of 3.7 per cent is less than the non-inflationary level of 4.6 per cent) and the decline in initial jobless claims to 40-50-year lows suggest a strong and sustainable growth traction,” says the report.

Further underlining the strong US growth view, the report says small business surveys exude confidence not seen since mid-1980s. They demonstrate a strong intent to hire, pay more wages, and an increase product prices. Senior banker surveys also suggest that there is an increasing willingness to lend to firms and households. In such a scenario, the Fed is likely to ignore market volatility and stay on its rate schedule.

The report says the recent softening in India 10-year government securities yields to 7.60 per cent is largely contributed by global factors, which are likely to reverse. “Our model fair-value for 10-year G-sec still stands at 8.4 per cent and expect it to harden toward 8 per cent by March 2019. We also maintain our INR/USD target at 75?The market is still above the fair value ?and our base-case for the Nifty stands at 10,400-11,000 over the next 12 months vs. 10,900 currently. Hence, our sectoral position is: Overweight on IT services, Pharmaceuticals, BFSI (primarily private banks) and Speciality Chemicals; Equal weight on Auto & Auto Ancillaries, Consumers, Oil & Gas and Metals & Mining; and Underweight on Capital Goods, Construction & Infra, Cement, Telecom, and Fertilizers & Agro Chem,” the report said.