Five Not so Common Spreads to Gauge Market Sentiment

The Rupee has been stuck in the 64-65 range against USD for some time now. A narrower range within this range has been 64.25-64.75. The realized volatility has been extremely low. The question playing on most market participants’ minds is whether it will break 64 first or 65. Whenever USD/INR has gapped up and looked like running away, heavy corporate and custodian selling has ensured that the gap gets filled the very same day. Whenever there is heavy selling, the Rupee just loses momentum on the downside as selling is absorbed gradually by the central bank and oil companies. Every time it goes up, it gives an impression that it would break away this time and every time it goes down it given an impression it will break down. But neither is actually happening and Rupee continues to trade in a range. One can avoid the false signals by looking at the big picture. In this article we discuss a few spreads that can be tracked which can give a leading indication of global risk sentiment. The primary fundamental driving factor for the Rupee has been global risk sentiment as global investors have been chasing yields in Emerging Markets on account of easy liquidity and low rates in DMs. If observed on a regular basis these spreads can be quite helpful in gauging market pulse, assessing risk sentiment and forming a view on USD/INR.

  1. USD/INR onshore-offshore spread: In the absence of any major domestic triggers, the offshore NDF drives the onshore. When the global risk sentiment is positive, EM currencies are bought for carry. Since there are no restrictions on foreign entities in trading offshore as compared to onshore, NDF is representative of the mindset of global investors i.e. whether they are risk averse or risk seeking. When the global risk sentiment is positive, the NDF forward points are lower than onshore. Therefore the spread is positive. When the risk sentiment is negative, the spread tends to narrow. During instances of carry trade unwinding, the offshore points may even be higher than onshore.
  2. CNY-CNH spread: This spread is the equivalent of the onshore-offshore USD/INR spread for the Chinese Yuan. CNH is the offshore non- deliverable forward in CNY traded in Hong Kong. Whenever the USD/CNH trades at a premium to USD/CNY, it is seen as negative for risk and Asian currencies in general. Off late, the PBoC has been intervening in the offshore market by pushing the funding cost of CNH higher by tightening liquidity there. This makes it more difficult to short CNH as cost of carry goes up.
  3. US-Germany 2y yield spread: Traders trading the EUR/USD pair use this spread extensively. As the yield differential goes up, it is considered to be negative for Euro. In recent times the US yields have been falling while the German bund yields have been rising. The economic data from the Eurozone has been coming in better than expectations while US economic data has been missing consensus estimates. The spread has been moving between 1.85-2.05. The spread factors in the hawkishness or dovishness of the US Fed and ECB as well as inflation expectations in the US and Eurozone. It is a market based estimate and is therefore forward looking. It indicates the preference of real money players. Though it does not directly have an impact on the Rupee, one can draw cues depending on the phase of correlation between EUR/USD and USD/INR we are currently in. Generally speaking, if the spread is widening primarily on account of an uptick in US yields, it is positive for USD/INR while if the spread is widening on account of German bund yields going down, it is negative for USD/INR.
  4. US 2s-10s yield spread: The spread between the US 10 year and the US 2 year bond yields indicates the steepness of the yield curve and therefore inflation expectations. Some times it is easy to get carried away by Fed speak. Therefore it is better to watch market based estimates. For example, in the recent FOMC statement outlined a plan for balance sheet trimming which should have been negative for 10y US treasury bonds i.e. yields should have moved higher. But after an initial spike up the 10y yields came back below 2.15%, which implies that the market at this point is not too perturbed by balance sheet trimming than was being made out to be. In general, a decline in 10s-2s spread implies a weaker US Dollar.
  5. US 10y yield-US 10y TIPS yield spread: The yield on the 10y US government bond is the 10y nominal yield while the yields on the 10y TIPS i.e. Treasury Inflation Protection Securities, can be considered as the 10y real yield. The difference between the two is the 10y inflation breakeven. Higher the inflation breakeven, the more hawkish the Fed is likely to sound and therefore it is USD positive.

All the macroeconomic data that comes in gets quickly reflected into these spreads. These spreads represent markets’ collective assessment of the data and therefore can be an indication of prevailing sentiment. One spread alone may not explain the move in a currency pair. One needs to look at all the spreads together and decide which one is likely to dominate. These spreads can be of help in forming short to medium term views.

Considering the extent to which vols are currently compressed, a volatility breakout is around the corner. Following are a few strategies that exporters and importers can adopt given the current set up of USD/INR.

For exporters having exposure in USD/INR, considering the fact that global liquidity has been chasing yields for quite some time now, a phase of carry unwinding is due. Also there is a stark divergence between commodities (proxy for growth expectations) and Emerging Market financial assets. To benefit from any spike in USD/INR on account of carry trade unwinding, exporters can consider hedging partial exposure through forwards and rest by buying ATM puts. The idea is to use the carry earned from forwards to fund the cost of plain vanilla put options. This strategy would work well for exporters using spot costing or spot + part forward costing model.

Exporters having medium term exposure in GBP/INR, EUR/INR, AUD/INR can consider hedging part of their exposure through Risk Reversals and partly through forwards. i.e. buying ATM puts and selling OTM calls so as to retain participation in case of an up move.

Importers having exposure in USD/INR can hedge a part of their exposures by buying ATMF calls. For example, July end ATMF call (64.75 strike) costs 33p. Therefore an importer contracting 1M exposures at spot 64.50 and costing using spot+forward can opt for this strategy.

Above strategies have been suggested with a view that there is a possibility of a volatility breakout in USD/INR in the near future as realized volatility has been compressed for a prolonged period. Technically, the Bollinger bands show a massive squeeze on the daily chart which suggests we could soon be moving out of the 64.30-64.75 range.

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