Rupee weakness: A flash in the pan or here to stay?

IFA Global

After the recent sporadic spike in the rupee to 65.90 levels from 64 within a few sessions, a little calm has been restored. The question plaguing the minds of market participants is whether the pullback that we have seen from highs is a retracement or whether it is the beginning of another leg of down move in USD/INR.

The foreign portfolio investors (FPIs) have been pouring in money into Indian capital markets, particularly debt in pursuit of higher yields (what is popularly referred to as the carry trade).

The recent surge in rupee was on account of carry unwinding attributed to concerns overs government not being able to meet its fiscal deficit target for FY18.

The rumours of the government possibly announcing fiscal stimulus measures to boost the economy spooked FPIs and triggered a bout of carry unwinding.

At the same time, broad US dollar recovery was also underway on account of hawkish September FOMC meeting wherein the US Federal Reserve announced the commencement of balance sheet reduction from October onward.

However, since then, things have settled on the global as well as the domestic front.

Though the employment data from the US has been encouraging with the latest data even indicating signs of pick up in wages (which had been missing so far), market-based estimates and household expectations of inflation are still running low.

The median dots on the dot plot indicate three hikes in 2018 but the market is pricing in just about one hike in 2018. The notion that the current low inflation need not be transitory and could well be structural in nature is what is preventing US yields and US Dollar from moving higher.

Though the short-term yields have moved higher and managed to sustain there, longer-term rates have not moved up to the same extent i.e. the yield curve has bear flattened which indicates weak inflation expectations.

The US CPI for September came in at 0.5 percent month-on-month, but the underlying inflation (core) continues to remain muted. About 75 percent of the rise in CPI was accounted for by the rise in gasoline prices due to supply disruptions as a result of hurricanes.

Going forward, core PCE, wage growth, retail sales and consumer confidence would be the most important data which would influence Fed’s policy decisions which in turn would set the tone for overall US Dollar strength/weakness.

On the fiscal front, nothing much is expected to move as getting tax plan and/or other reforms passed through Congress would be difficult for the Trump administration considering the political quagmire it is in.

Markets would keenly follow the decision on the appointment of the next Federal Reserve governor. Two leading contenders are Kevin Warsh and Jerome Powell.

While Warsh is believed to be more hawkish, the appointment of Powell would not change the status quo much. On the domestic front, the September CPI print came in at 3.28 percent; below market expectations of 3.53 percent, mainly on account of low food inflation.

August IIP came in at a nine-month high of 4.3 percent. This would alleviate to an extent at least for now concerns about growth slowdown and rising inflation.

There is a possibility that inflation could undershoot RBI’s expectations and this opens up room for a rate cut, not immediately though.

Pick-up in manufacturing activity, passenger and commercial vehicle sales indicate that the drag on growth due to GST and demonetisation could fade away.

Trade deficit narrowed to USD 9 billion in September, a seven-month low on account of revival of exports post the GST shock and improved demand overseas.

Concerns on the fiscal front also seem to be ebbing as direct tax collections are up 15 percent for April-September and 40 percent of budgeted direct tax has been collected during this period.

To sum up, as long as US rates remain benign USD/INR may spend some time consolidating in the new range 64.70-65.70. The downside in USD/INR looks limited, as inflows into debt markets are expected to slow down.

FPI limits in G-sec, in particular, are almost close to full utilisation. Inflows into debt markets were roughly balancing out the monthly trade deficit.

Considering near full utilisation of FPI debt quota limits and high equity valuations, the quantum and pace of inflows into capital markets that drove USD/INR lower from 66.20 to 63.60 is not likely to be seen from here on again.

As commodity prices firm up, FPIs would reduce their exposure to net commodity importing countries like India and prefer commodity-exporting emerging market economies instead.

Key factors that could result in rupee weakness are higher global crude oil prices, steepening of US yield curve, a further escalation in geopolitical tensions and fiscal slippage due to populist moves.

Exporters looking to hedge in the near-term can keep a stop below 64.60. Hedging using a combination of forwards and risk reversals can be considered to retain participation in case if rupee weakens. Importers can look to cover their positions on dips to 64.70-80 levels.

As far as crosses are concerned, Euro is likely to trade in a range 1.1650-1.1950 for the next couple of months. Gradual withdrawal of stimulus by the ECB is factored in the price to some extent.

Therefore the moves higher are not likely to be as swift as we have seen so far. The Catalonia secession risk is likely to fade away with Catalan pro-independence leader Carles Puigdemont and Spanish government likely to resolve the issue through dialogue.

Sterling is likely to be driven by Brexit negotiation related headlines. Any progress on more important trade-related issues is unlikely till issues of rights of Eurozone citizens in the UK, that of Irish border and Brexit bill (qmount UK owes to Eurozone) for the UK are resolved.

Markets are currently pricing in a 75 percent chance of Bank of England hiking rates in November. The Sterling could come under pressure if BoE refrains from doing so. Exporters can look to sell GBP/USD in 1.3380-1.3450 range.

Disclaimer: The author is Founder and CEO of IFA Global. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.