13 February 2006

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Having been involved with financial markets for a long time, I have learned several forecasting tricks, all of which have to do with not really saying anything. The first, and commonest, is to give a level but not a date - in other words, you could say the rupee will reach 46 to the dollar. Or that the dollar will hit 2.00 to the Euro. Or whatever. But you never say when.

Another, and less well known, rule, which is particularly valuable when the media is hovering close by, is to say something really outrageous, the thesis being that nobody pays sustained attention to the media anyway, so they'll certainly forget what you said in due course, unless, of course, your outrageous prediction comes true. There are not too many successful users of this rule. Marc Faber comes to mind, although in some senses, his wild predictions of gold at $ 2,000 or even $ 2,500 actually follow rule number 1 - he picks a price but not a date. So, too, his prediction that commodity prices could continue to rise for 20 years, or India's boom could continue for 20 years, and so on.

And then, there are the real fools, like yours truly, who - nudge, nudge - predict both a rate and a date. For example, back in July 2003, I said the rupee would be 38 (to the dollar) in 5 years. At that time, the rupee had already shocked everybody by strengthening against the dollar from a low of over 48 to about 46.50. Nobody quite knew what to make of it - the rupee had been falling steadily (and unsteadily) for years and everyone had planned their life with this as a given. Most people were frozen, unable to change their mindset.
My job, as I saw it, was to shake people out of their mindsets. Having a steel-reinforced mindset - a closed mind, in the colloquial - is the greatest limitation to growth and happiness.
The loudest example I know of this was the evolution of non-Euclidean geometry. As you may know, Euclid, who hung around Alexandria in 300 B.C., was the father of geometry. He had five postulates - simple things like "the shortest distance between two points is a straight line" and so on - which formed the basis of geometry. However, the fifth postulate - "that parallel lines never meet (except at infinity)" - while relatively easy to digest intuitively, could not be proved and kept mathematicians awake and working for - get this - centuries.
It was not until the mid-1800's that a German mathematician named Reimann came up with a novel way of addressing this conundrum. A classic method of proving (or disproving) a hypothesis was/is to assume the opposite and see whether you come up with something meaningful. For years/centuries, whenever mathematicians assumed that the fifth postulate didn't hold - by assuming, say, that parallel lines meet at 2 points (or 3 points) - the complex mathematical output that resulted were found meaningless in terms of the real world. And so, Euclid's fifth postulate remained (uncomfortably) accepted.

What Reimann did - and what was revolutionary - was he recognized that accepting the output of the test as meaningless was actually assuming the fifth postulate was true - in other words, peoples' minds were hogtied by the assumption (that the fifth postulate was true). And this went on for CENTURIES. Reimann instead accepted the otherwise meaningless outputs as a different description of reality. This led to the development of Reimann surfaces (which are theoretical constructs defined by these equations) and an entire new arena of mathematics called non-Euclidean geometry, the existence of which enabled engineers to develop much of the modern world we live in.

Clearly, cleaning out your mindset is an important activity, and we need to exercise is frequently - certainly more often than every 2,000 years.

Anyway, returning to July 2003, I didn't know how much the rupee was going to strengthen, but I did know that there were huge quantities of unsold dollars (old mindset) that would be progressively coming to market, which would embolden the trend of a strong rupee and that this would likely excite global investors, all of which could lead to a real bull run. Hence, the comment.

I like to believe the comment, which, of course, got a lot of press play, accelerated dollar sales into the market, making my forecast appear, for a period, sound, but, more importantly, began to change the mindset of several companies, particularly in the IT sector.

So much for changing mindsets and making forecasts. Coming to the present, I was looking at a medium-term chart of USD/INR last week and I thought I saw the emergence of a pattern. And, I thought to myself, what if that pattern were to repeat itself - as all our technical analyst friends believe they do. The pattern was something like this:

First leg: Sharp drop from 43.55 (Apr 8, 2004) to 45.60 (May 17, 2004)

Second leg: Mild correction, followed by a drop to 46.15 (Jun 22, 2004)

Third leg: High volatility, followed by a drop to 46.50 (Aug 2, 2004)

Fourth leg: Sideways movement, followed by a steady rise to 43.50 plateau (beginning May 2005 and running till Aug 2005)

I noticed that today

First leg: The market has risen sharply from 46.32 (Dec 8, 2005) to 44.96 (Dec 20, 2005)
Second leg: Then corrected mildly, and then risen again to 44.10 (Feb 1, 2006)

Could the market be moving into the third and fourth legs of the earlier pattern? If so,

a) the rupee would burst higher back to the 43.50 level by early April [a good budget would certainly boost inflows]

b) it would remain around that level for about a month [RBI would certainly protect 43.50]

c) and then slowly start to slip by early May [perhaps corporate results may not be as good as expected; perhaps export growth could slow]

d) the decline would accelerate from June onwards, with the rupee reaching back to 46.50 by September [current account deficit denizens rejoice]

Now, of course, as we all know, history never repeats itself exactly - nonetheless, there you have it - a fool's forecast! Enjoy!

Currency Market View - Rupee and Majors

INR-Fortnightly movement: O-44.2600 H-44.3400 L-44.0450 C-44.1850.
Sentiment: range bound with a stronger bias
Expected range for 1 Month: 43.80-44.50
Expected range for 3 Months: 43.50-45.00

The bulls continued to rule the roost as the rupee ended the fortnight 8 paise stronger after many range bound sessions. Markets witnessed a plethora of inflows as the Sensex breached the 10,000 mark. However, nationalised banks were major buyers, reportedly on behalf of the central bank, who would be keen both to contain rupee appreciation and improve the liquidity position in the money markets.

With foreign fund flow likely to continued, the rupee is poised to attack the 44.00; however incipient dollar strength in the overseas market will keep any gains short-lived. .

EUR Fortnightly movement: O-1.2102 H- 1.2188 L-1.1891 C-1.1905
Sentiment - negative but may improve
Expected range for 1 Month: 1.1875 -1.2400
Expected range for 3 Months: 1.1875 -1.2600

The dollar strengthened further last fortnight with the euro sliding as low as about 1.1890 before closing last Friday just over 1.19. Following the US employment report on Feb 3 (unemployment rate dipping further to 4.7%), markets are now factoring in at least 2 more Fed rate hikes. On the other hand, Eurozone data have been worse than expected. ECB officials continue to make hawkish statements but these are yet to be backed by a rate hike following the one in December. Consequently, the dollar managed to shrug off last Friday's report of a larger than expected US trade deficit for December.

From a technical perspective, the euro appears heavily oversold. A technical rebound appears very likely and this could extend into a larger rally if the ensuing US/Eurozone data turn out to be supportive for the euro. We still think this is likely but are ready to abandon our view should the euro fall decisively below 1.19.

GBP Fortnightly movement: O-1.7692 H- 1.7857 L-1.7376 C-1.7456
Sentiment: negative but may improve
Expected range for 1 Month: 1.7350 -1.8000
Expected range for 3 Months: 1.7350 -1.8300

Sterling also slid quite sharply against the dollar but managed to avoid a close below 1.74. It ended marginally firmer against the euro thanks to the rather disappointing Eurozone data.
We expect sterling to stage a decent rally from current levels but recognise that this may be contingent on getting support from the minutes of Bank of England's February MPC meeting as also the BOE's inflation report. Although the MPC kept its benchmark rate unchanged at 4.5%, any sharp reduction from the 8-1 majority at the January meeting will most probably be negative for sterling.

JPY - Fortnightly movement: O-117.04 H- 119.38 L-116.89 C-117.74
Sentiment: positive (for yen) and will likely improve
Expected range for 1 Month: 113.00 -119.50
Expected range for 3 Months: 109.00 -119.50

In the week ended Feb 3, the dollar rose as high as 119.40 far exceeding our anticipated cap of 118 yen with hardly any yen-supportive news. However, the yen appeared to have reversed course last Friday after a massive jump in Japanese core private machinery orders renewed expectations of an end to Bank of Japan's ultra-loose monetary perhaps as early as next month. Earlier on, the BoJ Governor said that core CPI is expected to be positive in January i.e. for a 3rd consecutive month and that the Bank's judgement of core CPI will become increasingly important from the next meeting on March 8 & 9.
If Japanese year-end repatriation as also unwinding of yen carry trades gain momentum, a decisive dollar break below 115.50 yen is all that may be needed for an eventual corrective dollar decline to 109 yen over a 3-month time frame.

Dr. Risk's prescription

During the current fortnight the dollar has strengthened further. The euro is down from about 1.2090 to 1.1975, sterling from 1.7675 to about 1.7440 while dollar/yen is up from 117.35 to 118.50 having already risen earlier this week to about 119.40. While the euro and sterling did dip intraday below 1.1950 and 1.74 respectively, they have yet to close below these levels. On the other hand, dollar/yen has again overshot our resistance level by a big margin. With market expectations for a Fed rate hike on March 28 rising over 90% after last week's non-farm payrolls and another possible hike later in May, the question uppermost in my mind is whether the temporary phase of dollar weakness is already over.

So far as the fundamentals are concerned, the dollar's strength in 2005 has been due to the dollar's increasing interest rate advantage with the record trade deficits being overwhelmed by large net capital inflows. This week's rather lackluster response to the US treasury auctions and the news that Nippon Life Insurance Company was likely to stay out of one of the auctions may perhaps bring the US trade deficit again under the spotlight. Today's US trade data and the market response may provide clues. As to US data, one swallow does not make a summer. US retail sales and inflation data due probably next week will naturally influence expectations of further Fed tightening. Bernanke's first semi-annual testimony on Feb 15 will likely show whether he will allow Greenspan's leaked comments that the market underestimates the extent of further Fed tightening, to preempt future Fed policy. I recollect in 2001 Wayne Angell, a former Fed Governor predicted quite a few times what the Fed will or will not do and I think got snubbed from Greenspan. This could happen to Greenspan as well if he keeps commenting on likely future Fed policy but next week there appears a slight risk of Bernanke offering a more balanced view without necessarily denying further rate hikes.

As to the Eurozone, while ECB officials have been repeating that the ECB is ready to hike interest rates, the market wants action. On the other hand, German data this week was worse than expected. On the Japanese front, BOJ is still non-committal about ending ultra-loose monetary policy. Besides, nothing seems to happening on the yuan front. But any market expectations that Japanese institutional appetite for US treasuries is waning significantly could lead to unwinding of the latest dollar/yen carry trades. According to reports, yen weakness was also linked to gold buying. If the latest correction in gold persists, we could see some further yen recovery. Japanese repatriation may also gain momentum with the approach of March year-end.

As to the Iran nuclear issue, I don't think it will hurt the dollar much as long as the 5-permanent members of the UNSC are united. So long as diplomatic solution is pursued, this may be a non-event. If sanctions are contemplated at a later date with P5 unanimity, dollar could even strengthen. The danger for dollar from this issue is unilateral US action or bilateral US/UK action with opposition from Russia and China. The precedent for this is what happened in the run-up to the 1991 Gulf War. Despite the bearish sentiment that was prevailing then, the dollar rose from about 1.44 to 1.54 against the DEM only to decline again as the war began with no resistance from Iraq.
Coming back, I still think another bout of dollar weakness, albeit temporary, is in the offing but am ready to throw in the towel if the euro falls decisively below 1.19 and dollar/yen rises decisively above 119.50. 'Decisively' is admittedly vague so I would guess 3 consecutive closes below or above, as the case may be, should suffice despite the ever-high chances of false breaks.