Why rupee is one of the best performer and near term outlook?

The recent out performance of the Rupee must have caught several market participants wrong footed. What warps one’s outlook on the Rupee is the notion that the central bank would intervene to prevent the Rupee from appreciating to maintain its export competitiveness. Its precisely because of this reason that several market participants would not have been able to quickly reassess their stance and re position themselves as USD / INR broke one technical support after another. Recent strength in the Rupee can be attributed primarily to five factors.

1)    Trump trade fade: The rally in US yields and Dollar index post Trump’s win gradually faded as markets came to terms with the fact that the White House would face significant legislative hurdles in pushing through with its ambitious reform plans. The Obamacare, Repeal and Replacement Act imploded, as it was not able to garner the requisite support in the House of Representatives. The bill had to be ultimately withdrawn and was seen as a legislative failure on the part of the government.

2)    Dovish Hike by US Fed: The US Fed delivered a rate hike in its March monetary policy meet but that was not enough to push the Dollar index and US yields higher. The rhetoric from various Fed speakers in the lead up to the policy had already shaped market expectations of a March rate hike. The market was looking forward to changes in the dot plot to ascertain if four hikes were likely but was met with disappointment. The market is currently pricing in 3 hikes for the current calendar year.

3)    Domestic Developments: Investors viewed landslide victory of the BJP in the state of Uttar Pradesh positively. The BJP was able to form the government in 4 out of 5 states that went to polls i.e. UP, Uttarakhand, Goa and Manipur. The win was seen as a decisive mandate for stability, continuity and pro growth, pro poor policies of the government.

4)    Limitation to Intervention: Though the central bank was seen arresting the USD/INR slide at crucial levels, as is evident from the central bank’s weekly statistics on FX Reserves, the deluge of inflows proved too much for the central bank to handle. The FPIs poured in a whopping USD 8.7Bn (Rs 57,000 Cr) into Indian capital markets in the month of March alone. The surplus liquidity situation post demonetization also limited the headroom for RBI to intervene, as unsterilized intervention would have exacerbated the liquidity situation. The RBI would have pushed the spot purchases of USD forward by buying in spot and then doing a sell spot-buy forward swap. By doing so it would have avoided infusing INR liquidity into the system. Another incentive for the RBI to intervene less aggressively would have been to use the exchange rate as a preemptive tool to tame headline inflation at a time when firming global commodity prices on account of reflation trades could have caused inflation to spiral out of its comfort zone. 

5)    Slew of Primary market issuance: Big ticket IPOs; QIP, Masala bond related inflows and M&A related FDI inflows also contributed to Rupee strength.

A large part of the Rupee rally has been driven by offshore. At one point, the spread between 1M onshore forward points and 1M NDF points had widened to 15 paise. Other factors working in favor of the domestic unit are: favorable current account situation with international crude prices hovering around USD 50/bbl mark, improving external debt situation, opening up of fresh FPI limits in G-sec and SDL and transfer of limits from long term FPI category to general category, implementation of policies pertaining FDI norms.

As far as relative performance is concerned, the Rupee has been the fourth best performing currency among its Asian peers since the turn of the year. Bilateral trade imbalances pose an even greater risk than competitiveness from export standpoint as India’s trade deficit with China accounts for 40% of its total trade deficit. While the Rupee has appreciated by almost 4.5%, the Chinese Yuan has appreciated by less than 1%.

The RBI is expected to maintain status quo as far as rates are concerned in its policy on April 6th. The focus will be on any announcements pertaining to standing deposit facility (for mopping up excess systemic liquidity without the need for collateral as in the case of reverse repo), restructuring of stressed assets and outlook on inflation.

 The Rupee could consolidate in the 64.50-65.50 range in April as sellers would look to capitalize on any up move to exit their positions. May has historically been a month when Rupee tends to depreciate. We could see the Rupee test 66.60 if seasonality plays out this time around as well. On the domestic front, the Met department’s forecast of the South West Monsoon would be keenly watched.

On the global front, the major risk event would be the French elections (First round of voting on 23rd April, followed be second round on 7th May). Opinion polls indicate that National Front leader Marine Le Pen and En Marche leader Emmanuel Macron would make it to the second round where Macron would prevail. Any development that enhances Le Pen’s chances would be negative for the Euro. The ECB is likely to maintain status quo in its April 27th policy meet. It would withdraw the stimulus only gradually so as to prevent a repeat of a 2011 like situation. Though PMIs, consumer sentiment and business confidence indicators have beaten expectations in Euro zone, inflation is yet to show definitive signs of picking up and private lending continues to remain sluggish. There is strong support for the Euro around 1.0490 whereas 1.0920 would be the major resistance level.

Post the invocation of article 50, any transitional agreement if sealed between the UK and the EU would be positive for Sterling as it would minimize business uncertainty. Gains in Sterling could be capped around 1.2740 in the medium term. 

Appendix

(Source: Bloomberg)

The Bloomberg cumulative FX carry trade index shows the carry earned by shorting USD and going long equal amounts of 8 emerging market currencies (considering investment in 3 month instruments). The return is highest seen since Feb 2015.

 (Source: Bloomberg)

The Bloomberg emerging markets capital flow proxy index (White) and the Nifty (Yellow).

India would continue to be the preferred choice as an investment destination for FPIs as long as the global risk sentiment is favorable (on the back of positive domestic developments and political stability). Nevertheless, the correction could be equally deep when the liquidity tide and risk sentiment turns.