31 July 2006

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Over the past year, the rupee has turned into quite a roller coaster, with a couple of heart-stopping collapses, the most recent of which took it briefly below 47 to the dollar, a more than three year record. Many companies are stuck with exports "prudently" covered at lower levels, some with excruciating long-term positions incorporating leveraged structures. On the flip side, most importers are blissfully open, since the rupee had been strong so long that they couldn't quite imagine this - their bliss is, of course, turning sour.

In some senses, this is par for the course given that our market, under RBI's deaf, dumb and blind hand, continues to remain in the limbo of neither here (fully controlled, fixed rates) nor there (freely floating). I don't think there is any doubt that we need to be there.

Hopefully, the report of Tarapore II, which is to be delivered today, will change all that.

In any event, Indian companies need to learn to ride the roller coaster, as global companies have been doing for several years. The chart shows the movement of the Euro versus the dollar compared to the movement of the rupee versus the dollar over the past seven years - since the inception of the Euro. Interestingly, the two curves have a positive correlation of 48.3%, almost exactly the correlation the Euro has enjoyed with the yen. This suggests that on a medium-term basis, the rupee is largely driven by global market movements - score one for liberalization of our external account.

However, as the chart shows even more loudly, the major impact of RBI's policies within this more liberalized external account has been the diminution of rupee volatility. Over the past 7years, the Euro has moved between 0.8290 and 1.3614, a range of nearly 50%; over the same period, the rupee has moved between 42.50 and 49.05, a range of about 14%. While one could claim, as RBI does, that this effort has assisted companies, one could also claim, as I do, that this effort has actually made risk management much more difficult since the process of volatility control actually results in sudden spurts of volatility that results in the kind of situation many companies find themselves in now.
There is a moral hazard created by any market belief and the regulator needs to recognize that its actions - in this case, intervening to prevent the rupee from strengthening which results in lower than reasonable rupee volatility - create these market beliefs, which, in turn, make dangerous positions seem reasonable. Rather than talking about targeting rupee volatility but actually targeting exchange rates, RBI should be more transparent and say nothing and do even less. Rather than trying to control the roller coaster, RBI should simply look to ensure that the tracks are clear.

Anyway, the reality is that - RBI notwithstanding - we are moving closer to a real roller coaster, which means that, just as in global markets, over any six or eight month period, we will see both low lows (excellent levels for exporters to sell) and also high highs (excellent levels for importers to buy). Already over the past six months, we have seen 44 rupees to the dollar and 47 rupees to the dollar; in the six months preceding that, we saw 43.25 and 46.25, again a range of 3 rupees. [Prior to that, the six month range for the rupee was - hold your breath - 43.25 to 43.85, an astonishing 60 paise, or around 1.5%.]

Going forward, I think it is safe to assume, we will see an at least 7-10% range for the rupee over any six month period, which, of course, begs the question - how do I manage my risk in such an environment.

Well, the first response would be to not look too far forward, since the longer you carry a hedge, the more likely it could end up way out of the money. On the other hand, not looking too far forward could expose you to considerable risk if the market got into a trend.

One via media that our advisers have come up with is to limit risk by selling/buying about 30-35% of your exposures out to 12 months. Then, depending on how the rupee behaves, you either pre-utilize the forward contracts (if spot is adverse) or go for spot, and top up the forward covers at what seem like appropriate levels. Obviously, this strategy, while useful does - like any strategy - carry certain risks, primarily that you may take (or update) the covers at a bad level - the rupee may trend in your favor for a full 12-months, resulting in mark-to-market losses on your forward positions. However, since the market tends to provide opportunity at both ends at least once every six months makes this a somewhat low risk. And, in any case, if the covers are taken based on protecting your benchmark, you would at least not lose money.

Net net though, the game has become a lot more risky, and will likely remain so. Thus, companies should correspondingly cut back on their risk-taking and accept a certain amount of opportunity loss as the price of not getting wiped out.

Welcome to the funfair!

Currency Market View - Rupee and Majors

INR

Fortnightly movement: O-46.4650 H-47.0400 L - 46.4300 C-46.6900.
Sentiment: Volatile; probably strong in the short term
Expected range for 1 Month: 45.75- 47.00
Expected range for 3 Months: 45.25- 47.00

Bears continued to rule the rupee in the first half of the fortnight before bulls overtook in the latter half. As a result, the rupee was volatile, with a range of nearly 1.5% and a breach of the psychological level of 47.00, a three-year low.

Escalating Middle East tension kept oil prices high, stoking dollar demand and sparking concerns about a widening trade deficit. A stronger dollar in the offshore non-deliverable forwards market added to rupee weakness as it provided an opportunity to buy dollars onshore and sell them overseas.

However, the rupee recovered rather smartly from its lows as dollar selling by exporters at higher levels offset dollar demand from oil companies and importers. The turnaround was accelerated by easing of oil prices from a record high $78.40 a barrel and also remarks from U.S. Fed chairman Bernanke, which indicated slowdown in the economy aiding views that Fed is nearing its interest rate peak. And, finally, RBI's rate hike at its quarterly monetary policy review (on July 26), with a growing sense that there may be more to come, underpinned the rupee's recovery.

Bearish undertone for the dollar globally and renewed fund inflows into the equity markets will act as positives, while oil demand and geopolitical tension may tame the rupee bulls. Overall, expect high volatility with a positive bias.

EUR

Fortnightly movement: O-1.2633 H- 1.2772 L-1.2459 C-1.2772
Sentiment - positive
Expected range for 1 Month: 1.2300 - 1.2850
Expected range for 3 Months: 1.2000 - 1.2850

Ahead of the Fed Chairman Bernanke's Congressional testimony on July 19, the dollar strengthened across the board on some better than expected US data relating to industrial production, capacity utilization and net foreign capital inflows into the US. However, Bernanke's neutral to dovish testimony and some weaker than expected US data especially Q2 GDP growth of 2.5% falling well below forecast of around 3% have the pushed market expectations of a Fed rate hike on August 8 further down from 50% a fortnight ago to just 28% last Friday despite strong US inflation numbers viz. core CPI rising 2.6% in the year to June and the core PCE price index rising 2.9% in Q2. Consequently, the Euro having initially fallen all the way to about 1.2460 has rebounded sharply by just over 3 cents.

From a technical perspective, the Euro's current rally could well terminate around 1.2840 and end a 3-phase correction of its earlier 5-cent decline from 1.2977 to 1.2478 but this will obviously require some positive surprises from the forthcoming US data this week viz. Chicago PMI, US ISM indices and the employment report.

We still maintain a bearish medium term outlook on the Euro, which will, however, be probably aborted in the event of a decisive break over1.2850.

GBP

Fortnightly movement: O-1.8377 H- 1.8673 L-1.8174 C-1.8623
Sentiment: positive
Expected range for 1 Month: 1.8000 -1.8800
Expected range for 3 Months: 1.7650 -1.8800

The minutes of BoE's MPC meeting in July showed an unanimous decision to keep the benchmark rate unchanged at 4.5%. However, very upbeat UK retail sales data and slight upward revision to Q1 GDP growth enabled Sterling to outperform the Euro last fortnight.
Sterling's currrent rally could well extend to the 1.8750-1.8800 area unless the UK PMI come in below expectations.

JPY

Fortnightly movement: O-116.27 H- 117.87 L-114.57 C-114.72
Sentiment: positive (for yen)
Expected range for 1 Month: 113.00 - 118.00
Expected range for 3 Months: 113.00 - 120.00

The yen slipped initially to 117.87 due to rising oil prices, North Korean standoff and some better than expected US data. However, the market's disappointment with Bernanke's testimony saw the dollar fall across the board. The Japanese yen benefited additionally from:

i) an 8th consecutive monthly rise in Japanese core CPI being perceived as providing ammunition to the BoJ for a 2nd rate hike later this year, and ii) the Chinese yuan firming last Friday to about 7.97 a dollar in the light of renewed spectre of US trade sanctions against China.

Continued yuan strength now could help the yen to strengthen further to about 113 a dollar before resumption of the dollar rally to 120 yen and higher. Only a decisive dollar decline below 112.50 may abort our medium term dollar bullish view.

Dr Risk's Prescription

Will the Fed hike next week? Damned if it does and damned if it doesn't!

Ahead of the Fed Chairman Bernanke's Congressional testimony on July 19, the dollar strengthened across the board on some stronger-than-expected US data viz. industrial production, capacity utilization, net foreign capital inflows and last but not the least, core CPI which was up 2.3% in the last 12 months and 2.9% annualized in the 2nd quarter. The Euro fell as low as 1.2459 while the dollar rose as high as 117.87 against the yen. However, Bernanke's testimony about moderating growth as also gauging the effects of prior tightening was perceived by the markets as a likely pause at the FOMC meeting on August 8. Consequently, the Euro rebounded to finish that day just under 1.26 while the dollar slumped against the yen to close around 116.75.

Thereafter, the US economic story has been somewhat mixed: an unexpected rise in the Conference Board's consumer confidence index, a larger than expected rise in durable goods orders, an unexpected fall in weekly jobless claims to just below 300k and a slightly larger than expected 0.9 increase in the employment cost index during the 2nd quarter. On the other hand, new home sales came in below expectations. However, what tilted the scales against the dollar was the Q2 GDP data last Friday showing estimated annualized growth of just 2.5% against forecast growth of around 3% and Q1 growth of 5.6%. The dollar slumped again with the Euro finishing nearly 1% higher at 1.2772 while dollar/yen tumbled over 1% to close around 114.72.

The market's expectations of a Fed rate hike on August 8 have come down to 28% from about 50% a fortnight ago. But in the last 6 months after Greenspan's retirement, such expectations of Fed rate hike at the 'next' meeting have jumped up and down like a yo-yo for a number of reasons including expectations of a slowdown in growth and the change in the text of the Fed's statement accompanying its rate hike decision. As Bernanke has said very simply, future course of Fed policy depends on the forthcoming data i.e. the future course of the US economy. Most reasonable and yet quite uncertain!

So what will the Fed do on August 8? Well, Q2 GDP may have been disappointing but not as bad as the 1.1% first estimate of GDP growth in the 4th quarter of 2005, which the market just shrugged off probably because Greenspan, a master of managing market expectations, was still in charge and the Fed funds rate was 100 basis points lower than the current rate of 5.25%. No matter how disappointing last Friday's GDP number is, it is still history unless by itself it points to a sustained slowdown ahead for the US economy. On the other hand, core CPI, the employment cost index and the high oil prices point to continued inflationary pressures.

It appears that the market is exaggerating the importance of Q2 GDP for the formulation of Fed policy almost in the middle of Q3! The market will have more relevant information about US economy and inflation from the data due this week such as personal income and spending, the ISM indices and finally the employment report.

There could understandably be 2 camps now: one which thinks the Fed will be damned if it hikes again for that prove to be the 'last straw on the camel's back' i.e. if it is not already broken and the other which thinks the Fed will be damned if it doesn't because it may only have to double up later on. The Fed does appear to be in an unenviable position but this could well change by the end of the week. And, even if the data continue to point to slower growth on the one hand and higher inflation on the other, the Fed may choose to hike on August 8. Of course, indications of a worsening US slowdown combined with receding US inflation may probably lead to further dollar declines beyond the lows seen this year.

Our medium term outlook for the Euro continues to be bearish unless the Euro rises decisively over 1.2850. Likewise, our bullish medium term view of dollar/yen gets aborted if the dollar falls decisively below 112.50 yen.