16 January 2005

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As the year turns, the world of market analysts appears to be divided into two - those, mostly in the U.S., who appear sanguine about U.S. growth and the likelihood of the Fed's continued success at managing a "soft" landing; and those, largely outside the U.S., who are a bit more uncertain, and include a goodly sprinkling of the "this-will-be-the-year-that-the-unsustainable-doesn't-sustain". These Jonahs, some of whom have excellent pedigrees, list a long series of problems in the world's economy, any of which could blow up leading to a major collapse, meltdown, what-have-you in 2006. Their lists comprise the usual suspects, with a large and, perhaps, disorderly, dollar decline finding place in every single list.

Indeed, some of them must be preening as the dollar is showing signs of stress. It has lost nearly 3% against the yen and a bit more than 2% against the Euro in the two weeks of the New Year, with unwinding of the carry trades (where investors borrowed yen and bought dollars) being hyped as one of the key drivers of the yen's serious surge.

The proximate cause of this unwinding is the belief that the Fed is closer to the end of its tightening cycle than had been previously believed - the release of the minutes of the December meeting appears to indicate as much. In fact, Dec 2006 Fed fund futures have fallen from a peak of 4.89% in November to as low as 4.61% in mid-January; a poll of 40 key analysts shows an average forecast of 4.73% for December 2006 Fed funds (albeit hiding a wide range of 3.50% to 5.75%). It would seem, then, that though there are outliers, the market broadly expects the Fed to push rates up no more than twice, which would take the funds rate to 4.75%, after which it would hold steady. Another possibility would be that they push it up 3 times (to 5%) and then cut back as growth slows in response. However, average forecasts for 2006 U.S. growth continue to be in the 3.25 - 3.50% range.

The dollar's response to all this has been surprisingly sharp, suggesting that sentiment may be turning. Perhaps, the end of the tax-driven inflows (under the Homeland Security Act) could have resulted in a coincident slowdown of dollar demand. Adding a bit is a general sense that growth in other major economies - notably Japan, but also (surprise surprise) Germany - may be picking up steam, which would lead to a narrowing of the interest rate advantage that had been favoring the dollar this past year. In fact, the ECB is on track to raise rates again.

All this adds up to a continued period of dollar softness in the immediate term.

If, into this mix, we get any negative news - whether technical (say, a fall of the ISM index below 50, a drop in consumer confidence, or whatever) or environmental (say, a renewed focus on global terrorism, Mr. Bush putting his cowboy boots back into his mouth, or whatever) - we could see the softness turn into weakness, pushing the dollar to - or below - our 3 month limits of 1.27 to the Euro and 106 yen.

This sort of sharp decline would doubtless result in a stampede of "I-told-you-so" analysts jumping aggressively on the dollar collapse bandwagon, which would, at first, accelerate sharply and then, when there was a large majority of cheering analysts on board, collapse.

The collapse of the weak dollar bandwagon could be triggered by a resurgent U.S. economy, which, by the 3rd quarter could show improving (though still bad) trade statistics, as ex-US global demand picked up, and perhaps, an uptick in inflation, forcing Governor Bernancke's hand. He will not want to fail his first test and will have to push rates higher, which would trigger a dollar resurgence, leaving the bandwagon confounded and licking it's wounds - yet again.

Of course, this is just one - and loudly contrarian - scenario, but time and again I have found (and tiresomely repeated) that the market's job is to prove the largest number of apparently intelligent people wrong. And since today there is a much larger number of apparently intelligent people who believe that the dollar has to fall (rather than rise), I believe the market will - as in 2005 - push the dollar to new highs (probably late) in 2006.

This would, of course, have implications for the rupee. If the dollar remains weak into the second quarter of 2006, RBI, who appears to have moved into a more relaxed, hands-off mode, could begin to get quite uncomfortable. With the current account deficit threatening 3% of GDP, a stronger rupee would be quite undesirable. Thus, we may see some sporadic firefighting by RBI to protect the 44 level, but it is unlikely that they will pull out all the stops, unless the dollar really weakens overseas and the rupee heads for its earlier peak of 43.50.
While some may argue that buying dollars (to prevent rupee appreciation) would have the secondary benefit of adding liquidity into a still "surprisingly" tight money market, my sense is that the increasing inflation threat would forestall this. The strong growth of the past few years has pushed the economy close to its capacity constraints, which is showing up in the "surprisingly" tight money. Simply pouring money into the market (which is what unsterilized forex intervention would do) risks igniting long-dormant inflation, which is anathema to any central bank.

Of course, once the dollar turns around overseas - which could be towards the end of the second quarter or a bit later - RBI will gratefully permit the rupee to fall, even if sharply, towards the 46.50 level.

Thus, we expect a highly volatile year, with opportunities for both sides of the hedging equation.

Near term exports should try and exit at any levels north of 44.25 or 44.30; fortunately the premiums have ticked up a bit (probably on ECB hedging in the thin market we have). Importers should set a 25 to 35 paise stop-loss and ride the dollar weakness for the next few months.

Currency Markets - rupee and majors

INR

Fortnightly movement: O-45.065 H-45.1225 L-44.1125 C-44.2375.
Sentiment: responding to dollar weakness overseas
Expected range for 1 Month: 43.80-44.80
Expected range for 3 Months: 43.25-44.80
The Domestic unit continued its appreciation rally yet another fortnight as the rupee gained almost 1.8% i.e. 83 paise stronger to close at 44.2375 on the back of greenbacks weakness in the overseas markets along with spurge in appreciation of many Asian currencies. Dollar weakness due to unfavourable data and good foreign capital inflows helped the domestic unit largely. FIIs exposures continued to increase, taking their total investment to a record USD 10.70 billion in Indian equity markets in the calendar year.
We expect some more year-end Dollar long position unwinding in the overseas markets, which may strengthen Rupee to near 43.80 levels where import demand is expected to limit further Rupee gains. Dollar demand is expected to remain weak in the immediate to near term against currency majors.

EUR

Fortnightly movement: O-1.1835 H- 1.2179 L-1.1801 C-1.2115
Sentiment - good and may probably improve
Expected range for 1 Month: 1.1900 -1.2450
Expected range for 3 Months: 1.1900 -1.2700
The dollar began the New Year with a sharp slide against the majors suggesting a multi-month period of consolidation following sharp gains in the preceding year. The slide began in the very first week with the release of minutes of the Fed's December 13 meeting suggesting that it is closer to ending its 18-month policy of hiking interest rates. This market perception seems to have been reinforced by a larger than expected drop in the US ISM manufacturing sector index and a weaker than expected non-farm payrolls report. After rising by about 3%, the euro dipped to about 1.20 last Thursday when the ECB President was unexpectedly silent, during his press conference, about the central bank's continuing inflation vigilance. The US trade gap also narrowed more than expected. The dollar's reprieve was, however, short-lived. The very next day, that is, last Friday the ECB President stressed the need for inflation vigilance and said that the ECB was not complacent. Besides, US retail sales ex-autos rose less than expected and the PPI report showed tame core inflation.

From a technical perspective, there is still a risk of the euro dipping to the low 1.19s before resuming its corrective rally to 1.2450 enroute to 1.27.

GBP

Fortnightly movement: O-1.7213 H- 1.7778 L-1.7183 C-1.7762
Sentiment: quite good and will likely improve
Expected range for 1 Month: 1.7300 -1.8000
Expected range for 3 Months: 1.7300 -1.8300
Sterling moved more or less in tandem with the euro. UK manufacuring output rose 0.4% in November. This was the largest monthly rise since last April but didn't bolster sterling much as the data matched market expectations. On the other hand, ballooning of the UK trade deficit to a record 6 bn pounds in November probably acted as a drag on sterling. Bank of England kept its repo rate unchanged at 4.5% as widely expected but the market perceptions are that the BoE is more likely to cut rates later this year as inflation is expected to undershoot the 2% target. This is in contrast to expected tightening by the ECB. Hence, sterling will probably underperform the euro in the months to come no matter what the movement is against the dollar.

Till sterling rises decisively over 1.79 there is a risk of a dip to the 1.74 -1.7350 area which should, however, provide sterling enough support for resuming its corrective rally to 1.80 and then to 1.83.

JPY

Fortnightly movement: O-117.84 H- 118.03 L-113.43 C-114.20
Sentiment: good (for yen) and will likely remain so
Expected range for 1 Month: 109.00 -115.50
Expected range for 3 Months: 106.50-115.50

The dollar's damage began during the NY session on January 3 i.e. the day the FOMC minutes were released and intensified in the evening after the People's Bank of China set the yuan's central parity rate at CNY 8.0702 per dollar, the highest level since the July revaluation. Although there has been no further revaluation since last July, the PBOC may well resort to other means such as frequent upward crawling adjustment of the parity rate with consequent implications for Asian currencies including the yen.

The dollar's shallow recovery in the fortnight ended December 30 and swift decline last fortnight suggest that our earlier 3-month target of 109 yen may well be reached within a month from now. The US fed funds rate is expected to be lifted to 4.50% later this month but any increase in market perception that the January hike will be the last could accelerate the unwinding of the dollar-yen carry trade into a near-panic stage, especially amid improved chances of an end to Bank of Japan's ultra-loose monetary policy. So don't be shocked if the dollar falls further towards 106.50 yen. Only a sustained rise over 119 yen at this stage will probably point to a resumption of the dollar's uptrend.

Interest rate markets

Bond prices fell towards end of week after early resilience as lingering tightness in liquidity weighed on market sentiment. Scarcity of funds with the main market player i.e banks pushed up call money rates to a 3 ½ year peak of 8.00%, up by more than 2% than sub reverse-repo levels of 5.50% where it trades when funds are ample.
According to the CBLO data, call volumes rose as high as 10818 crore on Friday with the weighted average rate at 7.54%. Mutual funds borrowed through CBLO's to meet redemption requirements in income funds.

The government went ahead with its borrowing programme despite shortage of funds in the system. The RBI auctioned 9.39% 2011 paper for 6000 cr and 7.40% 2035 bond for 4000 crore. Both the issues were fully subscribed. The cut-off prices almost met market expectations. Gilts were stuck in a range, with insurance companies showing its appetite for long-term bonds. Mutual funds continue to be active in short-term papers.

Major activity was witnessed in the new benchmark 5-yr paper, the 9.39% 2011 bond and the 8.07% 2017 bond (acting as 10-yr benchmark in absence of liquidity in 7.38% 2015 paper), aggregating volumes of around 2150 crore. Volumes in Gilts totaled close to 4000 cr during the week.

Market reacted little to government's decision of keeping EPF rate at 8.5%, backed the labour ministry. Lower EPF interest rate means more funds at disposal of corporates, which can be used in different investment avenues including government securities. Gilts fell after international crude prices tested 3-month highs of $65 a barrel on account of Iranian nuclear stalemate leading to potential disruption in supplies from the Middle East.

At the shorter-end, the cut-off yields in weekly T-bill auction mirrored the acute liquidity crunch in the market. The 91-day T-bill yield rose to 6.19% (prev: 5.94%) while the 182-day T-bill yield climbed to 6.22% (prev: 6.14%). Liquidity situation will improve once the government increases its spending. Advance tax outflows in December would come back to system once government uses the same. Global oil prices and movement in US Treasuries would continue to draw attention. Market participants might hesitate to take major positions in short and medium-term papers ahead of the quarterly monetary policy review on January 24. The RBI is unlikely to tinker with interest rates this time around, especially with inflation well under the desired levels of 5.00-5.50%. WPI inflation stood at 4.40% for week ended December 31.

The MIBOR swap rates moved up narrowly, despite the overnight rates peaking, as there are few receivers. The MIFOR rates continue to move up, reflecting the upward trend in forward premiums.