Hedging strategies before monetary policy meet

The next three weeks will see traders making two-way bets on the Monetary Policy Committee (MPC) policy review of October 3-4. Until the release of the August inflation numbers, consensus opinion was inclined towards a likely hike.

However, the August inflation numbers were low. The Consumer Price Index (CPI) showed 3.69 per cent advance year-on-year over August 2017. The Wholesale Price Index showed 4.53 per cent, year on year (Y-o-Y). Both numbers suggested a dip in the Y-o-Y inflation trendline, which was at 4.17 per cent (CPI) and 5.09 per cent (WPI) for July 2018.

The most obvious reason is that food inflation has dipped. Food has about 46 per cent weight in the CPI. At both wholesale and retail level, food inflation has dropped considerably to 0.9 per cent Y-o-Y. Food is a volatile item and it more than balances off the rising trend in fuels which is running at 8.5 per cent Y-o-Y. The Reserve Bank of India (RBI) would also examine core inflation trends, eliminating these two volatile items (food and fuel). Core inflation was running at 6.1 per cent in July and it also moderated, to 5.9 per cent in August.

Inflation is now below the RBI’s projection of 4.6 Y-o-Y in Q2 and into the lower end of the targeted band of 4 per cent plus/minus 2 per cent. 

So, there’s a case for holding rates, or even cutting. But the RBI would look at several other things.

It would have some idea of likely September inflation trends and it would make a call on whether inflation moderation is sustainable or due to transient base effects. It would look at GDP growth, and at the rupee. Finally, it would look at the impact on banking sector, which is still in crisis.

September fuel inflation is likely to be high, since crude prices have moved up. Food inflation would remain moderate. There seems to be a base effect for August 2018 versus August 2017, since inflation spiked in August 2017.

GDP growth would be good through the Q2 (July-September 2018) but likely to ease down in the second half. That’s due to the base effect of GST launch, and the lingering effects of demonetisation. Higher rates might lead to some growth retardation. The impact of a rate hike on banks is negative.

There’s enough there for doves to suggest that rates be held. The hawks can however, refer to the external situation and the rupee. Unless crude prices come down by some miracle, India is headed for a Current Account Deficit of about $75 billion - that’s about 3 per cent of GDP. This means the rupee could drop-in fact it’s guaranteed.

The RBI has already spent large sums intervening to stabilise the rupee. It seems to have decided on the pragmatic course of not trying to prop it up; just ensuring there’s no excessively abrupt declines. Since a large proportion of reserves consists of hot money, and there are substantial overseas repayments due, the RBI cannot afford to fritter away huge amounts of forex.

Higher interest rates offer an alternative means of currency defence. The US Fed is going to unwind its bloated balance sheet, and the European Central Bank could taper its ongoing Quantitative Easing by December. But higher rates may induce FPIs to maintain rupee-debt exposures. The debt market is also bracing for large second-half government borrowings. Debt market yields have risen in anticipation. The hawks will therefore lobby for an interest rate hike.

Minutes of previous MPC meetings suggest hawks outnumber doves but either side could win the argument. This means the Bank Nifty and other rate-sensitive stocks will see volatility through the next three weeks. If you’re long, hedge with deep out-of-money Bank puts. If you’re short, hedge with deep calls.