Anindya Banerjee Currency Derivatives Researcher, Kotak Securities
The market was so heavily long on the US Dollar going into the US central bank meeting that, anything short of declaring a definite date for a policy lift-off, would have caused a sharp correction in the US Dollar. Indeed, the market did not like the slight dovishness in the voice of the Fed members. We had been warning that US Fed might find the existing domestic and global macro-economic backdrop challenging enough to consider hiking rates now. Rupee gained smartly, towards 62.30 levels on spot, as year-end window dressing and hedging needs ensured that exporters stepped into lock in the higher US Dollar. Offshore traders reduced their long USD hedges post US FOMC meeting, and as result, we have seen the discount between offshore and onshore expand.
In the US FOMC meeting, US Fed downgraded its outlook on key economic variables, except for the unemployment rate. Central tendency forecasts for 2015 GDP were lowered to 2.3 - 2.7% from 2.6 - 3% in December as were those for 2016 GDP to 2.3 - 2.7% from prior 2.5 - 3%. Forecasts for 2015 inflation - as measured by core PCE price index was lowered to 1.3 - 1.4% from 1.5 - 1.8%. The 2015 view for the unemployment rate was reduced to 5.0 - 5.2% from 5.2 - 5.3%. Median Fed Funds forecast by end of 2015 was reduced to 0.625% from 1.125% and seen at 1.875% by end of 2016 from the prior 2.5% forecast. Only 2 of the Fed’s 17 members continue to see no rate hike in 2015. At the same time, US Fed dropped the word “patience” from its post-meeting statement. It can be a clear indication that consensus in the Fed is for higher short term rates before the end of 2015.
US Dollar has had a very rough sessions over the last two trading sessions, swinging wildly within a 300-500 pips range against majors. It seems, that in spite of the near term correction, we would not be surprised if US Dollar forces the US fed to become more dovish, by strengthening even more over the medium term. In a ZIRP world, currency is the new interest rate. Even before, the central bank can think of getting out of ZIRP, the currency would strengthen to a point where it may choke growth. We have observed similar predicament with Bank of England, who had to postpone any reversal of monetary policy, due to a very strong Pound, impeding economic growth.
A stronger US Dollar is seen as to have move deflationary impact on the world economy. However, impact of a stronger US Dollar on the US economy can be varied. With global commodities priced and traded in the US Dollar, a stronger Dollar exerts a downward pressure on commodity prices, especially when it strengthens by a big margin. On one hand, a stronger Greenback accentuates the pain in the US shale industry but on the other it can lower the cost of imports and as a result, it will augment the real disposable income of the US citizens, thereby creating an environment where consumption can improve. However, the big assumption is that there are no serious job losses in the US economy, due to a stronger US Dollar. In today’s time, there is contractionary impact from the shale and commodity producing industries in US but that may not be large enough to overshadow the improved real disposable income in the hands of citizens engaged in non-commodity part of the economy. However, if the global economic slowdown intensifies in the coming months, then it can cause a broad based slowdown in the American industry too, and during such a phase, a stronger US Dollar can become a net net negative for the US economy.
There are between USD 8-10 trillion of hedged and unhedged US Dollar debt floating in the financial system outside US. Within that, around USD 3-5 trillion have been raised by corporates from the emerging market. With debt priced in US Dollar and unhedged, it can become a drag on the business fortune when The Greenback strengthens significantly. The US Dollar is rising at a time, when real growth is falling around the world and nominal debt levels are high. Therefore, a weak real growth, falling inflation to deflation worsens the debt dynamics across the globe. Such an environment fosters an environment of deleveraging from the legacy debt. Higher the degree of deleveraging, greater is the constraint on demand and significant is the excess capacity within the global economy. As a result, a self-propagating process of a deflationary loop is created. We believe, more than US rate hike, a spiraling higher USD remains a bigger threat to global economic and financial stability.
Over the next week, traders will keep a close eye on the ongoing negotiations between Greece and Germany. We see the urgent need for a plan to reduce the Greek debt holding by a significant amount, to allow the economy to breathe freely. However, more than economics, politics has always been a bigger hurdle in the currency Union. EUR/USD has managed to enter a period of upward correction against the US Dollar. However, the upside remains capped between 1.12/1.16 levels, as divergent monetary policy expectation would continue to encourage traders to sell Euro on rise, rather than buy the dips. Back home, economic data has not been very encouraging off late. Government is doing their best to remove bottlenecks and help the economy mend itself. However, there is a trade-off between near term pleasure and long term ease. Steps which are being taken to shrink the parallel cash economy, which can one of the most positive reforms for long term, but over the short term, can engineer a deeper economic slowdown. We hope the government continues to prioritize long term structural repair over short term fixes. Over the coming weeks, we shall write about the issues facing the economy and what are the steps that the government needs to take to address it.
Indian Rupee can continue to swing within a medium term zone of 61.50/62.00 and 63.50/64.00. Importers are advised to cover payables below 62.00 and exporters can look to rallies above 63.00 to hedge. We expect that Indian Rupee remains well supported between 68.00/70.00 levels on spot, against the Euro and around 96.00/98.00 levels against the GBP. Against Yen, we favour a range of 50.00/50.50 and 52.50/53.00 levels on spot.