Anindya Banerjee Currency Derivatives Researcher, Kotak Securities
Volatility is back and it is back with a bang. After an extremely quiet August, where Rupee traded within a very tight range against US Dollar, we are seeing a good bit of two way movement in the pair. A string of weak US economic reports had initially caused reversal in expectation for a Fed hike in September and a result USD had dropped sharply from 67.00 levels to all way down to 66.32 levels on spot. However, the party in Rupee did not last long as strong intervention from RBI and later a sharp reversal in risk assets globally, pushed USDINR back towards 66.70 levels. As we write, offshore traders have taken Rupee towards 66.90/95 levels in NDF. On Friday night, a selling deluge was witnessed in the global markets, for no apparent reason. Though one can attribute the sell-off partly to the spike in odds for a hike on September but the overall odds remain at levels which is not indicative of a hike.
A couple of weeks back we warned about two issues. One seasonality favours a pickup in volatility in the September-October period and US Fed may look to test markets nerve by talking up the prospect for a rate hike. Hiking rates is not a preferred choice of US Fed but they are being forced to talk about it to cull excessive risk taking in financial assets. Fed is worried that too much complacency can foster parabolic upmoves in financial markets, which can later unwind and threaten financial/economic stability. One way to curb the flow of juices is to induce a dose of uncertainty surrounding the US monetary policy.
Over the past one month, economic momentum has stalled around the globe. A low and stable commodity prices had offered a seasonal bump up in global economic activity, as commodity producer witnessed some recovery in their earnings, from the abyss and global consumer nations were happy to get the benefit of higher real disposable income. However, low commodity prices is like a slow bleed for the commodity producing countries. The longer the prices stay in this range, which is what it is expected to do, the deeper the economic rebalancing these countries and companies will face. It does not matter how low is the operating cost for some of the commodity producers, what matters is that their lifestyle cost remains way above than what the current commodity prices can sustain. As a result, it is no surprising that it is a tale of two cities as far as outlook on manufacturing and services go.
Manufacturing is struggling globally, as the sector is most exposed to globalization due to its deep global links. Services on the other hand, is more domestically oriented. At the same time, services tend to be relatively low priced items of consumption than many goods of manufacturing. During times of economic weakness, it is therefore, services which tend to fare better than manufacturing. It is this strength of services sector which is keeping the global economy afloat. At the same time, the ultra-easy monetary policies have aided the economic muddle through in the medium term, though at a cost for the longer term.
Over the past two days, there has been heavy selling from the short volatility, systematic funds globally. These funds invest in both fixed income securities as well as in stocks. However, their strategies are designed to target volatility in a manner that when volatility is low, allocation to the asset increases. The exceptionally low volatile environment post-Brexit, where various measures of realised volatility had dropped to multi-decade lows, fanned excessive concentration in risky assets. At the same time, these funds thrive during times where bonds and equity are inversely correlated.
Therefore, during times when correlation between bonds and equities become positively correlated, these funds suffer. Over the past week, not only has fixed income and stocks become highly correlated but in both volatility has begun to rise. In such an environment, these mega AUM systematic funds would be forced to re-balance their portfolio and shed risk. The more they do that, the higher goes volatility and tighter becomes the correlation, leading to a vicious cycle of selling begets more selling kind of scenario. Therefore, currency traders need to pay close attention to these markets. Indian Rupee is expected to weaken towards 67.10/20 levels on spot, against US Dollar. Technically a break above 67.30 can cause a short USD squeeze. Key support is between 66.60/65 levels, which if broken will expose the previous weeks low of 66.30/32 on spot. Indian Bonds too can face some selling pressure due to the sell-off in global bonds.