Brace up for more volatility

In 2018, the rupee was one of the worst performing currencies amongst its comparable Asian and Emerging Market peer set, depreciating around 10 per cent against the US dollar.

A US rate hike cycle has generally been negative for emerging market currencies and therefore depreciation was not unexpected on account of outflows from capital markets. The rupee, however, underperformed its peers on account of elevated crude prices that brought the current account too under pressure.

The following factors are likely to give direction to the rupee in 2019:

Pace of Fed rate hikes

The US was the best performing developed economy in 2018. However, recent data seems to indicate weakness in the construction sector and housing market. Business fixed investment has been tepid given uncertainties on account of US-China trade tensions. While retail spending has been robust, durable goods orders have been a drag.

ISM manufacturing PMI, a leading indicator, suggests the weakness in data is likely to persist. Considering the slowing economy, the US Federal Reserve, which was earlier on course to hike rates thrice in 2019 may barely be able to hike once. While a pause in US rates would be positive for EM currencies, a risk off on account of fears of global growth slowing down, resulting in flight to safety could be potentially disruptive. Therefore it would be important to analyse the US data closely.

US-China trade negotiations

The impact of US-China trade tensions is more pronounced in Chinese data. There are evident signs of a slowdown in the Chinese economy. It would be important to track the US-China trade negotiations closely as the 90 day deadline approaches. Any escalation in trade tensions would be negative for the global economy. The Yuan has been off radar for some time now but the PBoC may be compelled to allow it to depreciate to act as a shock absorber for the economy if need be.

US politics

If the Mueller investigation into Russian involvement in 2016 US presidential elections dishes out any startling revelations on collusion, it could make president Trump’s position extremely precarious. Bipartisanship is likely to be difficult as is indicated by the ongoing partial government shutdown.

Crude prices

Crude prices would have a huge impact on the rupee. The current account deficit and domestic inflation would remain manageable as long as Brent prices remain below $70 per barrel. A spike beyond that level could spook the rupee again. While the OPEC, especially Saudi is likely to take measures to support crude prices; the US is likely to ramp up production.

Central bank activity

Central bank activity will also be a crucial factor driving the rupee. While a section of the market is now expecting a rate cut due to current benign inflation outlook, the impact of Rabi harvest, monsoons, and measures to alleviate farm distress taken by the government such as change in MSP model/loan waiver will have to be factored in by the RBI while setting rates.

General Elections 2019

Though the volumes are likely to be elevated as we head into general elections, as long as markets are reasonably assured of policy consistency and continuity, it may not have a lasting impact on the rupee. Any populist measures enacted by the government in the lead up to the elections would not go down well with investors. The centre’s April-November fiscal deficit is already 115 per cent of full year’s target. With GST collections consistently undershooting expectations, fiscal slippage is a concern.

Fiscal slippage concerns are, however, not fully reflected in yields at this juncture due to RBI’s aggressive OMO purchases. To summarize, rupee volatility is likely to continue in 2019. We may see the rupee settle broadly in a new range of 68.00 – 76.00 with a depreciating bias. The worst case scenario for the rupee would be a global risk off leading to outflows from domestic capital markets coupled with elevated crude prices putting strain on the current account (maybe on account of supply disruption due to geopolitical factors). It may not be easy to take a call on USD/INR looking only at broader US Dollar. We may see correlations between USD/DM and USD/EM flip flop in 2019.