11 September 2006

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The sudden jump in the rupee last week was doubtless related to the release of the report of the Committee on "Fuller" Capital Account Convertibility. Clearly, the market seems to believe that lesser control (which is what the committee's report represents) means a stronger rupee.

On reflection, this makes a lot of sense. An India with fewer controls would be more efficient, and, while volatility in financial markets would increase, so would growth. Higher growth would attract greater investment, leading to (amongst other things) improved infrastructure, which would feed the virtuous cycle. Looking at more mundane measurables, too, the medium term prognosis for the rupee appears bullish. For instance, the current account deficit this year is expected to rise towards 2% of GDP (I note that the committee has set 3% as the danger zone); however, capital flows, even at current levels, will quite easily finance this gap. Going forward, the growth in services exports should ameliorate the rising current account, with the growth in capital flows keeping the balance net positive or only slightly negative. Thus, and this was the argument put to us by the chief economist of one of the large international banks, the rupee, over the next few years, can only remain on trend - viz., market pushing rupee upwards, RBI resisting.

All very sensible. Unless, of course, there is a sudden shift in FII sentiment - again.

As we saw in May this year, the sudden increase in global risk aversion hit all markets, including India, and investment inflows dried up - indeed, some of it even pulled out. In fact, between May and July, the outflows equaled the inflows since January, so the FII account was flat as of July end. August has seen a billion dollars come in, which has propped up the stock market. However, the fact of some truly exotic IPOs, most of which are being roundly rejected by investors, does suggest that the market is a bit too high. The huge cash holdings of most companies and investment firms also confirms this sense.

On the other hand, it is clear that India Inc. is still on a tear. It is still well nigh impossible to find a company that isn't looking at 25-30% growth. And we're not just talking about the services sector. Which may suggest that the equity market is aching for a real correction, so that it can get back to its real business of reflecting underlying growth.

What could trigger this correction? Well, clearly, another shift in global risk aversion.

Returning to a favorite theme - although one that is beginning to show some signs of reality - it is extremely loud to me that the market appears fully convinced that the U.S. Fed has finished tightening interest rates. The futures market reflects an only 10% chance of another rise before year-end. This is a remarkably strong market view. [The only other one I can think of is that the rupee will continue to strengthen in the medium term.] Now, as regular readers of this report know, I like to be a contrarian - not just for the thrill of it, but because I have learned over the past few decades that the market likes nothing more than to laugh at a huge number of people scrambling around for their beachwear. Remember the old adage - when the tide goes out, you can see who's been swimming without any pants.
For the past several months, I have had a sense that the market is wrong about U.S. interest rates. The very fact that the dollar is holding its own globally despite an almost universal belief that the interest gap between the U.S. and the rest of the world is going to decline suggests that the market knows something we don't.

And just this morning, I was sent a newsletter by a friend, which put a very sound articulation on my gut feel. In sum, it says that the way the Fed tracks inflation - stripping out food and energy price variations to come up with a core personal consumption expenditure indeed (core PCE) is faulty. More importantly, this recent research was done at one of the regional Federal Reserve Banks, who's head is on the Open Market Committee. Using the new index (which simply lops off outliers rather than totally discards the volatile food and energy price indicators), inflation is quite a bit higher than believed. The full article is very interesting and can be found at www.frontlinethoughts.com.
This suggests that data out of the U.S. will keep increasing uncertainty, that Fed funds futures probability will rise towards 50%, that we will continue to see volatility in currencies about current levels, and that equities won't rise any further. When it becomes clear that U.S. rates will rise again, risk aversion will jump, the dollar will rally and we could see another outflow from the global markets. I note that the correlation between the Dow and the BSE has been nearly 85% in 2006 so far; the only difference has been the frighteningly higher volatility (42% versus 15%). Thus, if this does come to pass, domestic equities would be a terrible place to be in.
The rupee - well, given that RBI is still holding to its "less is more" approach to volatility, any rupee decline in response to global dollar strength may be limited to 46.50 or a bit lower. Importers could buy call options with a knock-in at, say, 46.50; exporters, who have much greater risk, need to be more conservative and keep selling piecemeal on dips.

Currency Markets View - Rupee and Majors

INR

Fortnightly movement: O-46.5500 H-46.5625 L - 46.0200 C-46.2250.
Sentiment: Volatile in a widening range
Expected range for 1 Month: 45.75- 46.75
Expected range for 3 Months: 45.25- 46.75

This fortnight witnessed strength for the rupee for the first time in many weeks, with support coming in from the FII inflows and dollar sales by foreign banks.

It started the fortnight on a positive note tracking the euro rise against the dollar and dollar sales by exporters and non-resident Indians. However, after the release of the Tarapore II report (on Sep 1) and the sudden strengthening of the yen, the rupee jumped higher in extremely volatile trade during the second week of the fortnight, reaching a eight week high of 46.02. Dollar buying was seen by oil importers and foreign banks, who were keen to arbitrage in the offshore non-deliverable forward (NDF) market. RBI also remained a buyer of dollars, judging from the rising reserves.

While sentimet for the Indian economy remains strong, which could improve capital flows, global markets appear more and more edgy. Look for volatility ahead, with any intrinsic rupee strength capped by overseas nervousness.

EUR

Fortnightly movement: O-1.2758 H- 1.2878 L-1.2651 C-1.2672
Sentiment - negative
Expected range for 1 Month: 1.2300 - 1.2800
Expected range for 3 Months: 1.2000 - 1.2800

During the week ended September 1, the Euro rallied over a cent following: 1) the release of FOMC minutes referring to the effects of previous rate hikes in the pipeline as also expectation of a gradual fall in the core PCE price index and 2) hawkish comments by the ECB President interpreted by the market as indicating a certain rate hike next month and a very likely hike again in December. Although the dollar recovered in response to the slightly better than expected US non-farm payrolls, it lost ground again on a perception of easing inflation pressures when the prices paid index in the ISM manufacturing sector report slumped from 78.5 to 73.

However, the Euro slumped by about 2 cents last week after the German Finance Minister cautioned the ECB President against a very restrictive monetary policy, Eurozone non-manufacturing PMI declining more than expected, strong US economic data and hawkish comments from a usually dovish Fed official.

Renewed speculation of further Fed rate hikes will likely cap the Euro under 1.28 and push it down for a likely test and a possible breach of 1.2450 in the next 2-3 weeks. Another factor that may depress the Euro against the dollar is a likely 'Humpty Dumpty' fall in EUR/JPY on continued unwinding of yen carry trades as the market focuses on the prospects of further BoJ tightening and on the implications of Eurozone officials' sensitivity to excessive yen weakness against the Euro.

We continue to maintain a bearish medium term outlook on the Euro. A decisive break below 1.25 will probably signal the resumption of the downtrend while a sustained rally over 1.29 may abort our bearish view.

GBP

Fortnightly movement: O-1.8866 H- 1.9090 L-1.8627 C-1.8654
Sentiment: negative
Expected range for 1 Month: 1.8400 -1.8800
Expected range for 3 Months: 1.8000 -1.8800

Sterling rose as high as 1.9090 partly on dollar weakness and partly on expectations of further rate hikes by the Bank of England to curb the UK housing boom. However, Sterling slumped last week by over 4 cents following larger than expected declines in UK PMI data, BoE decision to keep rates unchanged and news of Prime Minister Tony Blair battling to contain demands for him to indicate when he will hand over leadership of the Labour Party.
Renewed expectations of further Fed rate hikes are likely to cap Sterling under 1.88 before it falls further to 1.84 enroute to 1.80. Only an unexpected and sustained rise over 1.88 is likely to target 1.91 once again.

JPY

Fortnightly movement: O-117.26 H- 117.49 L-115.56 C-116.95
Sentiment: slightly negative (for yen)
Expected range for 1 Month: 115.00 - 120.00
Expected range for 3 Months: 115.00 - 125.00

Last fortnight's soft Japanese inflation data saw the yen slip to about 117.50 against the dollar, to a fresh all-time low of 150.72 against the Euro and an 8-year low of 223.81 against Sterling. However, last week's report of an unexpected surge in capital spending by Japanese firms revived fears of another rate hike by the BoJ this year and triggered an unwinding of yen carry trades which got a further boost on a German finance official's (unconfirmed) comment that yen weakness would be on the agenda at this week's G-7 meeting. The dollar had slipped by nearly 2 yen but has managed to recoup most of its losses on renewed expectations of further Fed rate hikes, Chinese Premier's comment that the yuan will gradually become more flexible - implying no revaluation and more 2-way volatility - and also perhaps due to US Tsy. Secy. Paulson's support for a strong dollar.

On any corrective downticks, the dollar is likely to find strong support in the 115.00-115.50 area before it rises decisively over 118 yen to 120 and higher.

Dr. Risk's prescription

Beware of Yen crosses

After reaching a new all-time high of 150.72 in the week ending September 1, Euro fell last week to a one-month low of 147.55 before finishing the week at 148.24. That is, Euro's gains against the yen in the previous 3 weeks were wiped out within a week. Likewise, Sterling tumbled last week against the yen to a 5-week low of 217.32 and ended the week at 218.14 after hitting an 8-year high of 223.81 in the week before. The story of Swiss franc against the yen is no different while that of the Australian dollar is just a little different in that it hit an 8-year high of 91.32 against the yen back in December 2005, slid to about 82 yen in the last week of March 2006 and then staged a smart rally that appeared to lead to a test of last December's high. However, the Aussie appears to have turned down once again last week from just under 90 yen to finish just over 88 yen.

The yen's apparent turnaround seems to have been triggered firstly by an unexpectedly strong Japanese capital spending report reviving hopes or fears of another Bank of Japan rate hike before the end of this year and secondly, a German finance official's comment last week that yen weakness will be on the agenda for discussion at this week's G-7 meeting. The US dollar had also slumped from about 117.50 by about 2 yen but managed to recover most of its losses and finish just under 117 yen on renewed expectations of further Fed rate hikes.

Last fortnight, we had mentioned that EUR/JPY had soared in the last 6 years after bottoming in October 2000 around 89 yen. A 50% correction could bring it down to about 120. Similarly, GBP/JPY rose from a low of around 148 in September 2000 to almost 224 in the week before last. A 50% correction could see this cross tumbling all the way to 186. As to Aussie-yen, it had risen from a low of 55 in October 2000 to 91 last December. Its recovery from an interim decline to 82 yen may well have ended considering last week's disappointingly weak Australian GDP report and AUD/JPY may have resumed its decline that could reach a 50% correction target around 73. You might counter that a 1.6% decline in Euro-yen and 2.5% fall in Sterling-yen are hardly harbingers of a 50% correction and you may well be right, but then 50% corrections do look very innocuous in the early stages and begin with humble 2% declines which then snowball into more severe declines.

Of course, the right fundamentals will have to be in place for yen crosses to fall sharply. One of them will be continued growth of Japanese economy combined with steady to rising inflation enabling Bank of Japan to progressively normalize interest rates and in turn, boost investment incomes and consumption of Japanese pensioners which in turn will again boost GDP. On the other hand, rising interest rates and possibly higher taxes in Germany could push down German business confidence and the Euro even lower. Political uncertainty in the UK could prove to be the Achilles heel of Sterling while the sharp slowdown in the Australian economy may already have tipped the Australian dollar into a larger descent.

You might well ask why we are silent about USD/JPY. It is certainly not immune from sharp declines over the longer term but may remain buoyant so long as US interest rates are headed up. Another important empirical characteristic of corrections in yen crosses is that a 50% price correction does not take half as long as the preceding rally. For example, a 50% correction of the 6-year rally in EUR/JPY may be over in say 12-24 months. That's because when unwinding of yen carry trades is in full swing, everyone is rushing for the 'exit door' at the same time creating a stampede.

At the moment, US dollar appears to be on the way up against the yen and we expect it to reach the 125-128 area in 6-9 months before falling back by 15 yen or so. Say, USD/JPY is at 110 when the yen crosses complete their 50% correction. That means EUR/USD will be 1.09., GBP/USD will be 1.69 while Aussie will be about 0.66. Now, 1.09 is also the 50% correction target for EUR/USD rally from 0.82 to 1.36. Of course, all the yen crosses will not finish the 50% correction at the same time which means USD/JPY could be higher so long as 110 proves to be a floor. In that event, GBP/USD could fall even a little lower to around 1.66 being its own 50% correction target of 1.37-1.95 rally. Having risen from 0.48 to 0.80 the Aussie could, perhaps, find a trough around 0.64 but a decisive break below 0.6775 will confirm a major double top reversal with a target as low as 0.5550!

Incredible? Time will tell but don't get shocked if last week's 'modest profit-taking' in yen crosses snowballs sooner rather than later into 'panic loss-cutting'.