| A DOG CHASING ITS TAIL |
14 August 2006
Looking closely at foreign currency reserves data makes it apparent that the recent sharp fall in the rupee was engineered by RBI. Since January 2003, there have been three instances of sharp rupee declines - from early April 2004 to the end of July 2004 (when it fell from 43.50 to 46.50); from mid-August 2005 to early December 2005 (when it fell from, again, 43.50 to 46.25); and finally recently, from mid-March 2006 to mid-July 2006 (when it fell from 44.50 to 47).
During the earlier two declines the reserves remained more or less steady, actually rising by a modest 1.8 bn and 0.8 bn, over the respective 4 to 4-1/2 month periods. These are very small numbers, certainly compared to the rise in reserves when the rupee was strengthening. Clearly, during both these declines, market demand for dollars was greater than supply and this drove the to a level that balanced the two.
The recent fall of the rupee, however, was quite different. It was accompanied by a sharp rise in reserves - they rose by nearly 17 bn over four months, a rate that was within 10% of the highest rate of reserve growth seen over the past few years. While part of this increase in reserves was due to the fall in the dollar internationally (which resulted in an increase in the dollar value of reserves held in other currencies), this was of minor impact. Assuming (for convenience of calculation) that the non-dollar reserves were all held in Euros, the revaluation impact on 100% of our reserves would be only around 7.5 bn. Now, since the bulk of our reserves are still held in dollars, the revaluation impact is certainly less - and probably much less - than that. This would suggest that over the past four months, RBI bought somewhere between, say, 13 and 15 bn dollars.
Now, 15 bn over 4 months is not a lot of money - hah! Well, that is in comparison to the domestic forex market that trades easily 15 bn a day! Thus, this demand would contribute only about 1% of the total domestic forex turnover. Nonetheless, it is important to understand that even such a modest imbalance can drive prices quite sharply, particularly if the market is positioned adversely. Ever since the rupee turned turtle in 2002, the market has imbibed the prospect of rupee strength, and for most of the period since, the market has been positioned either short or very short dollars. This could be because there are many companies that have 100% (or close to 100%) exports; they would doubtless be very keen to sell since rupee strength would affect their business disproportionately as compared to companies that are net short foreign currency (since imports seldom comprise such a high percentage of any company's business). Further, RBI's loud effort at preventing rupee strength - the steady buying of dollars - serves to reinforce the belief that the rupee is intrinsically undervalued. While this is probably true over the medium to long term, markets move based on short-term supply/demand forces and market users need to continuously tune their positions based on their targets and on "live" short-term views.
In any event, it is hard to understand why RBI would be buying dollars so aggressively. Exports were - and are - doing fine, despite the appreciation in the real effective exchange rate, which clearly does not correct for the impact of improved productivity, better (albeit marginally) infrastructure, etc. Perhaps, RBI was concerned that the market was getting concerned about the current account deficit - remember, at the turn of the year, there was talk that the current account deficit could cross 3% of GDP (in the event, it was well under 2%) - and that rather than let the market drive the rupee lower, it might be better to engineer the decline itself, reiterating its old-fashioned belief that a group of intelligent, focused and well-intentioned people can do things better than the market, which is merely hundred and thousands of people putting their money where their mouths are. Another positive of a weaker rupee could be supercharging growth of the services sector, which remains a key contributor to job growth.
On the flip side, of course, is the fact that a weaker currency pushes up domestic prices. Inflation has been rising globally and prices in India today are much more import-sensitive - imports comprise around 15% of GDP - and thus a weaker rupee feeds into inflation much faster than it did, say, five years ago. The WPI, which was under 4% in early March, is today above 5%, and while this may not yet be too dangerous a level, let us remember (a) that domestic petro prices are nowhere near reflecting global realities and (b) that we have already had two interest rate hikes during these months.
On balance, then, it appears that RBI bought dollars to weaken the rupee (to sustain strong export growth?); this, at least partly, contributed to higher inflation, which in turn, required RBI to raise interest rates (which, of course, cools lending and growth).
Sounds a bit like a dog chasing its tail, doesn't it??
Currency Market View - Rupee and Majors
INR
Fortnightly movement: O-46.5800 H-46.7800 L - 46.3800 C-46.5250.
Sentiment: Range bound yet volatile
Expected range for 1 Month: 45.75- 47.00
Expected range for 3 Months: 45.50- 47.00
The domestic unit traded volatile last week before ending close to its opening levels. After starting its fortnight on a stronger note backed by dollar weakness, it traded volatile for the next two weeks as bears and bulls continued to sway the unit either side.
Bearish trend of Rupee was on account of dollar demand backed by soaring crude oil prices. Oil prices traded around $76 a barrel following troubles in oil supply from Alaska, added to the mid-east crisis. Dollar also gained strength as BoJ decided to raise interest rates only gradually with dealers rushing to cover their short positions in dollars.
The short-run strength of USD was balanced by a weakening trend as European central bank and Bank of England almost simultaneously raised interest rates each by quarter percentage point. Dollar demand was further affected as FOMC paused its interest rate this time after rising straight for 17 times since June 2004.
An upgrade by Fitch Ratings also helped the local currency pull back from lows. It upgraded India's long-term foreign and local currency debt to 'BBB-' from 'BB+', with stable outlooks. The short-term foreign currency debt rating was also raised to 'F3' from 'B' and the country ceiling was upgraded to 'BBB-' from 'BB+'.
There were some decent foreign fund inflows into the stock market along with some commercial dollar inflows, which helped Rupee move in a narrow range. After touching highs of 46.78 and lows of 45.38 Rupee ended the fortnight slightly strong at 46.5250 close to its opening levels of 46.58.
With dollar outlook uncertain and further moves to be data driven, and given higher domestic demand from oil companies, overall rupee is likely to be seen trading range bound with a positive bias.
EUR
Fortnightly movement: O-1.2771 H- 1.2908 L-1.2706 C-1.2725
Sentiment - slightly negative
Expected range for 1 Month: 1.2300 - 1.2900
Expected range for 3 Months: 1.2000 - 1.2900
Despite an unexpected rise in the US ISM manufacturing index and better than expected data on US personal spending, construction spending and factory orders, the dollar was at the receiving end for most of last fortnight thanks to a larger than expected decline in the US ISM service sector index as also disappointing payrolls and unemployment data. The Fed maintained status quo last Tuesday as was very widely expected especially after the payrolls and unemployment data but has quite understandably retained the option of further tightening should the rising core inflation not begin to abate in response to the slowdown in growth. For a while the dollar appeared to be on the verge of an extended decline but recovered rather smartly following upbeat US retail sales data. Still, Fed funds futures contracts show just a 33% chance of a September 20 Fed rate hike leaving ample room for further dollar strength in the event of buoyant US data.
The Euro rose all the way to about 1.2910 before retreating
and finishing last Friday at 1.2725. From a technical perspective, a minor double top
around 1.2910 and the break below 1.2765 could push the Euro down to the low 1.26s before
it finds its feet.
We still maintain a bearish medium term outlook on the Euro. A decisive break below 1.26
will probably signal the resumption of the downtrend while a sustained rally over 1.29 may
abort our bearish view.
GBP
Fortnightly movement: O-1.8641 H- 1.9141 L-1.8615 C-1.8902
Sentiment: slightly negative
Expected range for 1 Month: 1.8300 -1.9200
Expected range for 3 Months: 1.8000 -1.9200
Sterling shrugged off worse than expected UK PMI numbers and
soared way above our expectations to reach a 13-month high of about 1.9140 following an
unexpected rate hike by the Bank England on August 3 and the disappointing US payrolls the
very next day. However, Sterling slid by about 2-1/2 cents last week after a less hawkish
than expected BoE quarterly inflation report and the announcement of a foiled terrorist
plot to blow up trans-Atlantic flights.
From a technical perspective, bearish RSI divergence suggests caution. Stochastics and
momentum have also turned down and probably point to further declines. Yet, a decisive
break below 1.88 is probably needed to rule out new multi-month highs.
JPY
Fortnightly movement: O-114.64 H- 116.44 L-113.98 C-116.28
Sentiment: negative (for yen)
Expected range for 1 Month: 114.00 - 118.00
Expected range for 3 Months: 114.00 - 121.00
The yen strengthened initially to just beyond 114 on speculation of another Chinese yuan revaluation and comments by BoJ officials that another rate hike later this year couldn't be ruled out. However, the yen resumed its decline thereafter in response to the Japanese Q2 GDP growth being reported to be an annualized 0.8% against the forecast of 2%, BoJ Governor not indicating any time frame for further tightening and the larger than expected rise in US retail sales.
The dollar is likely to have resumed its medium term uptrend.
Dr. Risk's Prescription
Has the Fed done a volte face?
A disappointing US non-farm payrolls number of a mere 113k in July against a forecast of 145k and a rise in the unemployment rate from 4.6% to 4.8% depressed the market expectations of an August 8 Fed rate hike further down to around just 20% despite evidence of a rise in core inflation - core PCE price index - to 2.4% from 2.1% just a month ago. Since a Fed pause was almost fully priced in, Fed Chairman Bernanke and all but one of the FOMC voting members seemed to have thought that there was little to lose in maintaining status quo as long as they remained ready to hike interest rates further if warranted by forthcoming data.
The dollar gyrated a bit wildly after the Fed's announcement but finished up last Tuesday. It slipped again on a market reassessment of the outlook for Fed policy but got a boost last Friday from US retail sales which rose 1.4 percent in July as against a forecast rise of 0.9% and a 0.4% drop in June. The ex-auto sales too rose an upbeat 1% compared to an expected rise of 0.4% and an actual gain of a mere 0.1% in June. Just a day earlier, the Euro had touched an intraday high of 1.2908 only to slump as low as 1.2706 after the data and close last week at 1.2725. Sterling had already soared to 1.91 plus after the unexpected Bank of England rate hike and the dismal US payrolls in the earlier week. It made a new 13-month high of about 1.9140 after the Fed announcement but retreated to finish last Friday around 1.89 after a less hawkish than expected BoE quarterly inflation report and the news of a thwarted plot to blow up trans-Atlantic flights. The dollar had slipped down to just under 114 yen after the US payrolls data but recovered strongly last week to about 116.30 yen after disappointing Japanese Q2 GDP growth'. Despite the buoyant US retail sales in July and the persistent inflationary pressures, Fed funds futures contracts show just a 33% chance of a 25 bp Fed rate hike on September 20. The concerned traders may be thinking that 'one swallow does not make a summer' and that forthcoming US growth data may more than offset any positive impact of last Friday's retail sales data. One analyst even seems to think that the Fed is bluffing and has no intention at all of hiking rates further but to say so would lead to an unwanted rise in long term interest rates and hurt the US economy even more. He adds that CPI is a lagging indicator, current inflation is much higher and so interest rates should also have been much higher. This analyst even goes on to say that inflation is the only way Uncle Sam can indirectly repudiate his debts without actually appearing to do so. There may be an element of truth in that last statement for one former Treasury Secretary was reported to have said, "The dollar is our currency but your problem". Still, so far as Bernanke is concerned, the jury is out though he may appear to have risked his credibility by last week's pause.
To sum up, we expect US inflation to inch up further in the near term and the Fed funds rate to be hiked to at least 5.75% or perhaps even 6% before the Fed 'calls it a day'. In the event, inflation begins to turn down quickly the Fed may stay put and say, "We told you so". The Fed could, perhaps, end up having the best of both worlds but right now they surely seem to be walking a tightrope with the risk of falling on either side.
From a technical perspective, a minor double top around 1.2910 and the break below 1.2765 could push the Euro down to the low 1.26s before it finds its feet. We still maintain a bearish medium term outlook on the Euro. A decisive break below 1.26 will probably signal the resumption of the downtrend while a sustained rally over 1.29 may abort our bearish view.
The dollar is likely to have resumed its medium term uptrend against the yen. Any downticks are likely to be limited to 115.25 before the dollar surges past 118 towards 121 yen and beyond. While an unlikely decline to 114 or lower may only prolong the consolidation and delay the resumption of the dollar's uptrend, a decisive break below 112.50 will probably be needed to abort our medium term dollar bullish view.
