Just 2 months back, in mid-May, the Dollar was at 58.5, and the consensus talk was about it going to Rs.55. Today, it is at Rs.61.5 and the panicky market movements suggest that it is looking like a currency crisis again. What happened?
Declaimer: This article written was originally in June 2014, and some of the data points may be outdated.
Well, that was an excessive irrational movement and so is this. The market runs to excess most of the time and is very rarely in equilibrium. Like a seesaw, it moves to excess one way and then the other.
Most exporters were oversold in mid-May, while importers had stopped hedging. Now exporters are covering their excess shorts, while importers are running to fix their exposures.
But what triggered this enormous change of sentiment?
The “Modi Mania” of mid-May was an India-centric factor, while the current sentiment is driven by a global factor, i.e. US and Europe.
The first wave of hardening happened when the US reported a 4% GDP growth rate for Q2, CY2014. This came on the back of a -2.9% GDP growth rate in Q1CY2014, which happened because of the very bad weather during that quarter. It is not genuine, permanent growth…..just a restocking of inventories that had depleted in Q1. The long-term potential rate of growth is ~2%, and current projections are for 1.7%.
This sudden news triggered expectations of faster tightening by the Fed, maybe by Q2, CY2015. It was dampened by the poor Job Creation numbers and the uptick in Unemployment to 6.2%, still above the full employment number of 5%.
On the back of this, Italy reported recessionary numbers and Germany, the engine of Europe, a slowdown. This has raised expectations of a full-blown QE by the ECB in its 7th Aug, ’14 meeting. There has been huge short-selling of the Euro against the Dollar, leading to a Dollar-positive sentiment, which has pushed up the DXY to a technical breakout point of 81.6. The Euro has dropped to 1.3340, another technical support point.
So what to expect now?
The ECB will loosen for sure, i.e. drop Interest rates, and launch a QE, but those expectations are in the price. Unless the ECB does something dramatically excessive or shows a panic reaction, the Dollar: Euro should not break 1.32.
The impact on the Dollar: INR has been excessive because of the recent exuberance in mid-May, where most people were oversold below 59. Those stop-losses have been triggered, so you see these panic candlesticks.
For those with staying power, this is NOT a currency crisis like Aug 2013.
One, the Euro monetary loosening has been anticipated for a long time. Two, while the US uptick in GDP was a bit of a surprise, the subsequent Unemployment numbers indicate that this is just a one-time uptick. The US Current Account Deficit has come in lower than expected, but this was expected, given the expected increase in Shale Oil production over 2014-15.
Most of this movement can be traced to the Euro loosening. India is not at the epicenter of this, we are just suffering from the aftershocks. Our Inflation numbers are down, the monsoon is better than expected and food inflation might stay under 18% this year. Interest rates have been kept tight, with an indication that they will continue till Jan 2016, even if inflation trends are down to 6%.
Most importantly, we have increased Fx Reserves by a dramatic 20% (~$50 bn, not including $35 bn of Fx Swap lines with Japan), so the RBI has enough firepower to prevent a currency crisis like mid-2013. And the flows are continuing to come…..
Another minor point is that the RBI accumulated $20 bn of Forward positions in May, at 58.5-59 (public information). With carry for 2 months, their cost would be at 60.5. These positions could get liquidated to douse the panic and reduce short-term volatility. This is over and above the $13 bn accumulated in the spot market during the same period.
So what do we do now?
For now, hold these positions, which are not large. The carry will return most of your MTMs in a couple of months. The next quarter’s GDP growth rate for the US should come in lower and the tapering should be over. Any indication of longer-term horizons in the Interest Rate hikes, or a slower trajectory (than 0.25% per quarter) will lead to a selloff in the US Dollar. Till then, the carry will catch up.
If Indian inflation continues its decline, the Rupee will remain in its range of 60-63. This is not scary.