| LOOK OUT BELOW - VOLATILITY RISING |
8 May 2006
In media circles, summer is known as the "silly season", and with the temperature rising, the champas and bougainvillea in full bloom, I feel a bit silly myself. And so, I thought, perhaps I should take another shot at forecasting the rupee over the next 3 months or so.
The last time I did that was back in February this year [A fool's forecast] when I projected that, under pressure from capital inflows, the rupee would strengthen towards 43.50 around April, hold at that level for a while and then fall towards 46.50 under the weight of the increasing current account deficit. I was clearly way off. In the event, the rupee simply wobbled around the 44.25-35 level till mid-March, after which RBI bought dollars aggressively - over $ 13 bn in the six weeks since March 10, the highest level since (surprise, surprise) the previous March - to manage the "sudden" tight domestic liquidity situation. This, of course, took the rupee sharply. Interestingly, it bounced off the 45.31 level intra-day - see below - and is currently a tad stronger at 44.80.
The chart shows a somewhat deformed reverse head and shoulder pattern, with the peak (head) at 46.32, the base at 45.00 and the shoulders (neckline) at around 45.30. Classic technical analysis suggests that unless the neckline is decisively broken, the market will move to recapture the entire move from base to peak - i.e., a target of 43.70 or so. Of course, as with most forecasting processes, it doesn't set any sort of time horizon for the target, so we are left somewhat in the air.
However, I also see that the long-term (120-day) average has just started turning upwards. The last time it turned upwards substantively was in October 2004, after which the rupee moved from around 45 to 43.75 in the space of three months. Of course, as we all know, history doesn't repeat itself - certainly not exactly. And there is also that ominous rooftop pushing downwards on the chart, suggesting that the rupee will need to get up a real head of steam to be able to thrust above the 44.55-44.65 level that it is covering up.
On balance, I would say that technicals point to a stronger rupee.
Again, the fundamental supply/demand balance of dollars in the domestic market is also skewed towards a stronger rupee, notwithstanding sky-high oil prices and the steady growth in imports. Indian companies are aggressively increasing their global borrowings and, of course, exports, particularly in IT, pharma and jewelry, continue to surge. Indian equity markets, of course, remain global darlings - the shocking $ 6 bn in application money collected by Reliance a couple of weeks ago is testament to the fact that there is a huge amount of money (both global and domestic) that is still chasing Indian stocks, and even though the market has surged to unforeseen levels, there doesn't seem to be any real cooling off - everybody is saying they are nervous, but they're still buying.
In fact, the only force keeping the rupee from strengthening is RBI's continuous high-level intervention. In the six weeks to April 26, it has purchased a record $ 16.5 bn to keep the rupee from asserting its intrinsic strength. While the intervention prior to the end of March was, perhaps, justified to defuse the year-end liquidity tension that had built up in the domestic money market, it is difficult to understand why they are still at it.
First off, the liquidity support effort was extremely successful - by last week, the reverse repo window was currently flooded with extra liquidity to the tune of 50,000 cr a day on average, and, in fact, RBI is now talking about the need to mop up excess liquidity. Exports are growing quite well, thank you, even exceeding their robust target last year, so there does not appear to be any threat to competitiveness from the rupee's value. And, from an inflation-fighting standpoint, a stronger rupee would help to take the sting out of the government's plan to release some more of the global oil price rise into the market, which is expected to be as soon as the assembly elections are over.
Perhaps more importantly, the continuing intervention is pushing rupee volatility back down and some corporates are already starting to take hedging decisions based on the belief that RBI will contain volatility. This makes a mockery of RBI's frequently stated goal of getting companies to manage risk more objectively, and threatens to reverse the recent evolution of better risk management by corporates, as evidenced, for example, by the significant increase in volumes in the domestic options market.
And, as surely as night follows day, this constant pushing against the market, will surely result in a sharp upward breakout of volatility some time in the next few months. It is very hard to determine whether this will be in the direction of a stronger rupee or the reverse. Historically, the rupee has usually weakened when volatility has broken out. Of course, this would probably require the dollar to strengthen sharply overseas, which could happen if it falls to sharply and the Fed surprises the market. On the other hand, the dollar could continue weak and investment flows could continue strong, which would push the rupee higher - all, assuming, of course, that RBI recovers its sound sense of recent months.
Now, for my forecast.
Well, I will chicken out from providing a level or even a direction. But I will forecast that rupee volatility will rise over the next two months, which means buying options provides not only a good hedge but also a possible trading opportunity.
Currency markets - Rupee and Majors
USD/INR
Fortnightly Movement: O-45.1000 H-45.1500 L-44.7700 C-44.9250
Sentiment: range bound with a stronger bias, influenced, however, by RBI's stance
Expected range for 1 month: 44.50-45.25
Expected range for 3 months: 44.25-45.50
The rupee was very calm in the preceding fortnight as compared to wild movements in major currencies overseas. On the downside, dollar buying by oil companies on the decline in crude prices to below $75 a barrel, pulled the rupee down to 45.15. Despite the dollar's sharp decline overseas, suspected intervention by RBI limited the upside in the rupee to 44.79. Forex reserves rose to a record $160.677 billion (up by more than $3 bln) during the week ended April 28 reflecting RBI's dollar buying spree in recent times.
With the RBI unlikely to allow rapid rise in the rupee, we might not see too much strength in the immediate term. Premiums could ease a bit from current levels, given that liquidity is abundant in the money market.
EUR
Fortnightly movement: O-1.2371 H- 1.2762 L-1.2331 C-1.2716
Sentiment - positive
Expected range for 1 Month: 1.2500 -1.2900
Expected range for 3 Months: 1.2300 - 1.2900
Fed chief Bernanke's hint of a pause in the current Fed tightening cycle seemed like a final green signal to a market already intent on selling dollars for a host of other reasons such as central bank diversification of reserves, dovish comments from several other Fed officials, geopolitical tensions, etc. So much so that the market ignored all the upbeat US data that was released most of last fortnight, embraced good Eurozone data and finally, pounced on a disappointing US payrolls number. That is, indeed, sentiment personified! And, you can never argue with the market where might is right!
The Euro crossed our earlier 1-month target of 1.2650 just within a fortnight and appears to be on course to reach our earlier 3-month target of 1.29 very soon and possibly the current fortnight itself. Overshooting can't be ruled out but don't take it for granted. What thereafter? With the US economy appearing as robust as ever, dollar sentiment will probably take a turn once again for the better with Fed officials getting hawkish again. Asian/Middle East central banks may also not be in a big hurry to implement their 'reserves diversification plans' with US 10-year treasury yields becoming more and more attractive.
From a medium term perspective, there seems no reason to believe that the correction of the Euro's overvaluation has finished. The Euro's medium term downtrend is likely to resume by the end of June. So the most likely course for now is a rise to 1.29 followed by sideways consolidation in a 5 to 6 cent range.
GBP
Fortnightly movement: O-1.7873 H- 1.8622 L-1.7794 C-1.8593
Sentiment: positive
Expected range for 1 Month: 1.8300 -1.8900
Expected range for 3 Months: 1.8000 - 1.8900
Contrary to expectation, Sterling outperformed the euro thanks to UK retail sales and manufacturing as well as non-manufacturing PMI far exceeding expectations. This batch of 'sterling' data seems to have dashed the market's long-persistent expectations of a Bank of England rate cut and may have possibly even kindled hopes of a rate hike in the not too distant future. Consequently, Sterling rose last fortnight by about 4% to about 1.8620 before finishing just under 1.86.
Any dips on profit taking are likely to be limited to 1.83 before an exhaustive rally to 1.89.
JPY
Fortnightly movement: O-115.83 H- 115.94 L-112.25 C-112.58
Sentiment: positive
Expected range for 1 Month: 111.50 -115.50
Expected range for 3 Months: 109.50 - 115.50
The market response to the G-7 call for stronger Asian currencies was far more powerful than anticipated. The dollar gapped down and opened under 116 yen when the markets opened on April 24 following the G-7 meeting. That very day, the dollar fell through the 115.50 support and closed around 114.50. After Bernanke's hint of a pause, the dollar tumbled even below the 113.50 support to reach as low as 112.25 yen.
Any upticks are now likely to be limited to 115.50. On the other hand, the dollar appears very much oversold and any further decline may be limited to 111.50 during the next one month and to 109.50 over a 3-month period especially since China appears to be content with its 'crawling peg' and Bank of Japan seems to be in no mood as yet to hike interest rates.
Dr. Risk's prescription
Has the dollar fallen into a bottomless pit?
Fed Chairman Bernanke's Congressional testimony on April 27 reiterating that Fed policy was now dependent on US economic data and hinting at a pause in the Fed's monetary tightening, seemed to have been music to a market that had already begun suspecting as much from the speeches of several Fed officials. This happened close on the heels of the Swedish central bank reducing the proportion of its dollar reserves from 37% to 20%, the Russian finance minister saying that the dollar was not an absolute reserve currency and the G-7 communiqué calling for a strengthening of the Asian currencies; especially the Chinese yuan. Consequently, the dollar's decline accelerated with the Euro and Sterling finishing the last fortnight up by 2.8% and 4% respectively and the dollar sliding against the yen by 2.8%. So the question that could be nagging many is whether the dollar is on its way to the lows seen in late 2004. In other words, are the Euro and Sterling on their way up to 1.36+ and 1.95+ respectively and is dollar/yen on the way down to 101?
The dollar's decline last fortnight was, indeed, dramatic considering that almost all the US economic data was better than expected. The only exception was last Friday's non-farm payrolls. Of course, data from the Eurozone and the UK was also upbeat but what seems to have made all the difference is the market view that the Fed is unlikely to hike rates at its end-June meeting, that the ECB is likely to hike rates 3 times before the end of the year and that the dollar-euro interest rate differential is likely to keep narrowing for the rest of the year once the Fed hike on May 10 is out of the way.
The primary factor that drove the dollar higher during 2005 seems to have been fairly robust US economic growth combined with rising short term US interest rates. Although April non-farm payrolls fell far below expectations this is more likely a temporary aberration. Besides, payrolls are considered to be a lagging indicator and not a leading indicator. With other US indicators namely, retail sales, consumer confidence, durable goods orders, new and existing home sales, manufacturing and non-manufacturing ISM indices, personal income, construction spending and non-farm productivity being quite robust, it seems unlikely that the US economic growth will slow down sharply though a moderation from the 4.8% annual rate in Q1 to around 3.5% is by no means unlikely. As to inflation, core CPI has been benign for an unusually long time and rose 2.1% in March on annual basis. However, with oil and several commodity prices ruling near record highs and showing no signs of reversing, to keep US inflation in check, the Fed is likely to hike rates further even if it chooses to take a break in June following 16 consecutive hikes including the assumed May 10 hike.
Former Fed Chairman Greenspan was a master in managing and guiding market expectations. In comparison, Bernanke may seem to have fallen short considering that he had to issue a clarification that the markets had misinterpreted his latest comments about future Fed policy. In all likelihood, this is a transitory phase.
So reverting to US interest rates and the dollar, the market could again get hawkish about Fed policy in 4 to 6 weeks, if not earlier. Till then, the dollar will very probably fall further but to a limited extent. Euro may rise to 1.29; Sterling may rally to1.89 while dollar/yen could fall to about 109 before the dollar's medium-term uptrend resumes. The dollar's downside against the yen will probably extend if China abandons its 'crawling peg' or Bank of Japan hikes interest rates but at the moment neither seems to be in the offing.
