| ONE MORE DOWNWARD BURST? |
28 August 2006
With the rupee having slipped into a narrow groove around 46.50 for nearly a month, and many companies still nursing wounds incurred as a result of overdoing exotics during the last phase of rupee steadiness, most companies are waiting and watching with relatively modest levels of fresh cover to a relatively short horizon.
Over the medium term - say 6 months - fundamentals do point to a stronger rupee. The fact that RBI is still buying dollars suggests that the supply demand equation in the domestic market is skewed towards excess supply [of dollars]. Exports are stronger than ever, invisibles are growing apace and, on the capital account, Indian companies continue to borrow heavily overseas. The remittance story and fresh investments, notably in real estate and private equity, remain large contributors. Thus, even though the current account deficit is growing, the India story remains untarnished - to the contrary it continues to shine brighter than ever to judge from the growth plans of a wide array of companies we speak with. The real estate and HR markets, too, are signaling high demand, particularly at the high end. The equity markets do look a bit rich, but with such a good story and so much loose cash in the world, it is hard to see India not benefiting disproportionately when world markets settle down.
The question, as always, is when world markets will settle down and whether there will be some terror in the process - there usually is. Currently, the "R" word has come back rather loudly into global market parlance. With the U.S. economy - notably the housing sector - appearing to slow quite rapidly, markets are quite convinced that the Fed has completed its tightening cycle and will likely hold interest rates steady for some time. Interestingly - and oddly - while there are no projections (that I have seen) that are looking for U.S. growth slower than the 2.5% rate seen in the 2nd quarter, there are several views that the "slowdown" will actually drive the Fed to - some time in 2007 - begin to cut interest rates again.
This hardly makes sense. Globally, things look pretty good - even Eurozone growth is looking healthy - and, while U.S. growth is usually an independent variable, and while the U.S. housing slowdown is obviously quite real, my belief is that the inter-connectedness of global economies and the huge demand apparent in the service sector in India (particularly for people) will enable the world economy to chug along reasonably well - a kind of Goldilocks with hiccups.
This would suggest while U.S. interest rates may, indeed, have peaked for this round, this belief will likely be questioned - and, possibly, questioned loudly - from time to time over the next several months. There are several other markets that are also signaling that the nervousness that came to light around May this year, while moderating, is not yet over.
While currencies are, relatively, becalmed, volatilities in many other markets are higher than they have been for years - in some cases (copper, gold), they are at, or close to, all time highs. However, it may be significant that the volatility of copper has been falling of late and, while it is still extremely high at over 40% (compared to a long term average of around 20%) it has come down from the near-60% levels it had reached. Perhaps, this is another sign of the market settling down. Emerging market debt spreads are much higher than they were, say, three years ago, although here, too, they have moderated. U.S. growth itself has become highly volatile, but this is really the definition of the issue. And, finally, companies and investors are sitting on record piles of cash.
What does all this mean? Could the huge pile of cash mean
that, sooner or later, it will pour into financial markets, driving asset prices higher
again? [Go, BSE?] Or, does it mean that people are very wary about future growth and are
holding on to cash as a hedge against recession?
I don't know. It could go either way, and so, it's not a time to take any big bets.
Correspondingly, any strong accepted wisdom is probably a good opening for a contra bet.
As I mentioned earlier, the strongest accepted wisdom in markets today is the belief that
the Fed is done with tightening and will begin to cut rates in 2007. About a month ago,
Bill Gross, who runs PIMCO, which is the largest bond fund in the world, announced to all
and sundry that the bear market in bonds is over - clearly, be must have gone long some
time before that. By now, it would seem certain that the market is quite strongly
positioned long U.S. bonds. Thus, any signs of even reasonable U.S. growth, which, in my
view, is extremely likely, could see bond yields jump nervously.
While I am no longer a betting man, I'd take a small wager that the Fed funds futures, which today are predicting a mere 19% chance of a rise in interest rates before the end of the year, will fall (futures prices move in opposite direction to yields).
If, indeed, this does come to pass, it would probably spell yet another surprise bout of dollar strength, which would doubtless reflect on the rupee. As I reported some weeks ago, the rupee has been remarkably well correlated with global movements in the dollar, albeit with RBI's volatility attenuation. And, since, for reasons best known to them, RBI does appear to want a weaker rupee - they continue to buy dollars, after all - if the dollar does surprise world markets, the rupee could, in the near term, slip downwards off its 46.50 perch.
Other than the impact of surprise global moves, we must also recognize that there hasn't been any internal trauma for a long time now - sorry, let me correct that, there hasn't been any market moving internal trauma for some time. Clearly, anything negative - or knee jerk negative (like, for instance, Manmohan Singh resigns and is replaced by Sonia Gandhi - an excellent idea, by the way) - would also push the rupee lower.
Any of this could have significant impact because, in
general, the domestic market usually sits short dollars. This is because rupee strength
hits exporters top (and bottom) lines more dramatically than rupee weakness hits companies
who have imports. Again, there are significant amounts of short dollar positions being
rolled over in the market as a result of greedy positions taken by companies during the
last spell of rupee steadiness.
Thus, if the rupee does start to wobble downwards, we could see a rush of short covering,
which could take it back to threaten, and perhaps breach, the recent low of 47. This, of
course, should be seen as an opportunity to sell (dollars) aggressively, and I would look
for the rupee to recover back to 46 (or even better) by March next year.
Currency Market View - Rupee and Majors
INR
Fortnightly movement: O-46.5550 H-46.6250 L - 46.4050 C-46.5600
Sentiment: Narrowly volatile
Expected range for 1 Month: 45.95 - 46.80
Expected range for 3 Months: 45.50 - 47.00
The domestic unit remained in a tight range of less than 0.5%, ending the fortnight at 46.56. In many ways, the rupee is reflecting the narrow volatility in global markets.
Despite resurgent inflows into the equity markets, which took the Sensex above 11,500, the rupee showed little upside, perhaps taking a cue from the yen, which remained under pressure as chances of the BoJ increasing borrowing cost for a second time this year remained grim. On the other side, easing crude prices - which fell from $76 per barrel to trade around $72 - as geopolitical pressure eased in the Middle East helped the rupee ward off any month-end demand pressure.
Inflation edged higher to 4.92 percent for week ending August 12, higher than both the previous weeks figure of 4.82 percent and market expectations. With a build up in Inflationary pressures, any further weakness in the rupee would be unwarranted. Expect rupee weakness to remained curbed on increased foreign fund flows and the currency to trade in a range yet again, albeit with a stronger bias.
EUR
Fortnightly movement: O-1.2739 H- 1.2938 L-1.2694 C-1.2752
Sentiment - neutral
Expected range for 1 Month: 1.2300 - 1.2900
Expected range for 3 Months: 1.2000 - 1.2900
The Euro was supported just under 1.27 before rallying all the way to 1.2938 on upward revision of Eurozone Q2 GDP, softer than expected US inflation data and a sharp drop in the University of Michigan consumer sentiment index. However, the Euro relinquished most of its gains following a much larger than expected decline in the German ZEW economic sentiment index and hawkish comments from Chicago Fed President Moskow.
The Euro has traded between 1.2450 and 1.2950 for 4 months and seems ready for a range breakout. Having failed again around 1.2950, the Euro now appears more likely to move to the lower end of the range. It may even fall decisively below 1.2450 if the forthcoming US data viz. Q2 GDP revision and August payrolls surprise on the upside leading to a renewed speculation of a September 20 Fed rate hike.
We still 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-1.8926 H- 1.9022 L-1.8777 C-1.8883
Sentiment: neutral
Expected range for 1 Month: 1.8500 -1.9000
Expected range for 3 Months: 1.8000 -1.9000
Sterling moved sideways in a 250 point range before ending the fortnight almost in the middle.
An unexpected decline in UK July retail sales pushed Sterling down to around 1.8775. However, Sterling recovered by more than a cent after a Confederation of British Industry report showed a rise in UK factory orders to a 20-month high in August.
We are still bearish on Sterling from a medium term perspective. However, Sterling's decline from the 1.9141 high on August 8 has been been gentle like a downward drift or a bull flag unlike the sharp rally from the 1.8378 low on July 26. The current boundaries of the downward sloping channel are around 1.8715 and 1.8980 and the daily drift is about 12 pips. Until we see a decisive break below this channel, one can't rule out new multi-month highs.
JPY
Fortnightly movement: O-116.22 H- 117.40 L-115.15 C-117.23
Sentiment: negative (for yen)
Expected range for 1 Month: 115.00 - 120.00
Expected range for 3 Months: 115.00 - 125.00
Despite US data last fortnight being mostly softer than expected, the dollar found support over 115 yen, recovered smartly last week on a renewed rise in oil prices following Iran's refusal to halt uranium enrichment. Much weaker than expected Japanese inflation data and consequent waning of market expectations of another BoJ rate hike before the year-end propelled the dollar over 117 yen at the end of last week.
From a technical perspective, the dollar seems poised to surge to 120 yen within 2-3 weeks, consolidate in a 3-4 yen range for a while and then rally again towards 125 yen. An unexpected dip below 115 yen will probably delay the dollar's bull run but is unlikely to abort it unless the dollar falls decisively below 112.50 yen.
Dr. Risk's Prescription
Where is the Euro headed?
Last fortnight, we have seen the Euro rise against the dollar from the low 1.27s to the low 1.29s on softer than expected US data and then relinquish most of the gains following a sharp drop in the German ZEW economic sentiment index and hawkish comments from Chicago Fed President Moskow, to finish in the mid 1.27s. Sterling also rose about a cent to the low 1.90s before dropping about 2.5 cents to about 1.8775 after a disappointing UK retail sales report. However, Sterling managed to recover over a cent and close last Friday around 1.8880 after a rise in UK factory orders to a 20-month high. We continue to be bearish on the Euro and Sterling in the medium term with targets of around 1.10 and 1.66 respectively while at the same time being aware that our bearish view would probably be aborted if the Euro rises decisively over 1.29 and Sterling over say 1.9050.
As to USD/JPY, the uptrend seems to have already resumed and last week's much softer than expected Japanese inflation data is likely to lead to acceleration in the uptrend towards 120 yen initially with an eventual target of around 128 yen.
Such a dollar rally would obviously require a sea-change in the market's current perceptions about any further Fed rate hikes. We believe this will occur as a result of a turnaround in US growth and payrolls as also a continued rise in US annual core CPI for some more time.
Now moving to our headline question, what is the significance of Euro crosses - especially EUR/JPY - for the likely trend of EUR/USD? Let us consider this in some detail from a techno-fundamental perspective.
EUR/JPY: From October 2000 till date, EUR/JPY has moved up from about 89 to almost 150. This can be largely attributed to Bank of Japan's quantitative easing policy (since discontinued) as also 4 rate hikes of 25 bps each by the ECB since last December. Has the EUR/JPY multi-year rally ended conclusively? Perhaps not. While one target of 149 has already been reached, there is also another target of 156 which could also be attained. This is a mere 4.7% from current levels of around 149 and there are many combinations of EUR/USD and USD/JPY that can push EUR/JPY to 156. One possibility is USD/JPY reaching 128 and EUR/USD falling to about 1.2190. On the other hand, if EUR/USD reaches 1.30 in the near term, USD/JPY could be capped around 120 yen. Considering the present bullish trend of USD/JPY, it could peak somewhere between 120 and 128.
Now consider what happens to EUR/JPY thereafter. Considering the sharp rally, a multi-month correction could push it down to around 130 while a deeper correction could see it decline to 123 or even 116. An across the board yen rally could be accompanied by declines in EUR/JPY, USD/JPY and EUR/USD as well, as has happened from time to time. This could come about as a result of higher Japanese interest rates or much stronger yuan or both on the one hand and German slowdown on the other due to monetary tightening by the European Central Bank as also likely fiscal tightening by Chancellor Merkel through higher taxes. We would expect at least a 50% correction in EUR/JPY targeting around 123. Having rallied since the end of 2004 from 101 yen levels to say 124 yen, USD/JPY could fall to say 110 yen in which case EUR/USD is headed for a sharp decline to around 1.12. Of course, there could be many alternative scenarios but one thing seems very likely and that is EUR/JPY will embark on a 'Humpty Dumpty' fall quite soon and in the process, EUR/USD will very probably be a casualty as well, even if it turns out to be an unwitting one.
For now, those with Euro receivables may be able to adopt a wait and watch attitude but beware if EUR/JPY falls directly below 145 or EUR/USD falls decisively below 1.25.
