Rising dollar raises eyebrows: Will it cause pain to our very own rupee?

Global Dollar Strength: Implications for Rupee and EM currencies.

After a prolonged period of USD weakness, we are finally witnessing a period of USD strength that has managed to sustain long enough to debate whether global macro economic factors have changed to warrant a fundamental change in outlook for the USD. The question is whether the recent USD strength is on account of actual improvement in US macros (actual pick up in inflation expectations) or on account of weakness in other major currencies due to their own specific factors (EUR, GBP, AUD and JPY)

How much of USD strength is on account of better US macro?

USD weakness was a result of unwinding of Trump trades that had been initiated in anticipation of a strong fiscal push that was expected to drive up US yields and the US Dollar. The inability of Trump administration to push through reforms resulted in unwinding of reflation trades. Lack of pick up in inflation despite economy being close to full employment gave the US Federal Reserve the comfort to hike rates and shrink its balance sheet gradually. As a result global liquidity started chasing emerging market assets in pursuit of higher yields, which in turn resulted in a phenomenal rally in emerging market stocks, bonds and currencies. Though recent data from the US suggests that inflation and wage growth are finally showing signs of picking up, they remain well below the Federal Reserve’s target of 2%. Moreover inflation excluding food and energy i.e. core inflation continues to remain soft. Headline inflation has been higher on account of gasoline prices that have moved higher due to hurricane induced supply disruptions. As long as structural pick up in inflation is absent, the US Federal Reserve is likely to persevere with its policy of removing accommodation very gradually. This implies that there is no immediate threat for EM assets from Fed policy in the near future. The key risk for EM assets stems from any breakthrough on the legislative front, especially passage of tax reforms*. The US president has set Thanksgiving as the deadline for the passage of the tax reform bill. It would be interesting to see if tax reform turns out to the first legislative victory for the Trump administration.

How much of USD strength can be attributed to weakness in other currencies?

A large part of recent USD strength can be attributed to weakness in other currencies due to specific factors. The ECB’s stance was dovish. Though the ECB trimmed asset purchases to EUR 30Bn per month from EUR 60Bn, it reiterated flexibility with respect to duration and size of future asset purchases. The timeline for the first hike has therefore been pushed further into the future. An element of political uncertainty introduced by the Catalonia referendum and ensuing developments have also weighed on the common currency. The Spanish government invoked article 155 and revoked autonomy of Catalonia, bringing it under Madrid’s direct control. Fresh elections in Catalonia are scheduled for December 21st.

The Sterling continues to be driven by Brexit related headlines. The BoE is likely to hike rates in its November policy but pace of future hikes is likely to remain slow on account of Brexit related uncertainties. The Aussie Dollar has broken down after weaker than expected CPI numbers. The RBA is expected to keep rates at current low levels well into 2019. With Shinzo Abe consolidating his political position post the snap election in Japan, Abenomics is likely to continue and this should keep Yen from appreciating sharply.

Implications for EM currencies

As long as USD strength is on account of weakness in other currencies due to their own specific factors, it is not likely to weigh on EM currencies. We could head into a phase where USD strengthens against majors and weakens or trades sideways against EM currencies. Key risk to EM currencies stems from hardening US rates on account of tax reform in US which looks more likely now than earlier. For Rupee in particular domestic factors can assume greater significance. With FPI debt limits close to full utilization the pace of Rupee appreciation seen earlier is unlikely. Performance of BJP in Gujarat state elections will be closely watched. Management of fiscal deficit by the central government and details regarding issue of recapitalization bonds will also be tracked. Any further uptick in global crude prices could result in a sell off in bonds due to higher inflation expectations. Crude sustaining above USD 55 per barrel and US 10y yields breaking above 2.50% could act as triggers for next leg of up move in USD/INR. 64.35 on the down side is a crucial support in the near term.


*The bone of contention between the Republicans and Democrats pertains to the elimination of SALT deduction (State and Local Tax). In order to fund other tax cuts (doubling of standard deduction, cut in corporate taxes etc) republicans have proposed elimination of SALT deduction wherein US citizens filing federal taxes can claim deduction for property tax and local taxes. Elimination of this deduction would hurt the Democrat controlled states with higher tax rates. Considering the slender majority that republicans have in the senate (52-48), they can hardly afford any defections at all. If the tax reform is passed without elimination of SALT deduction, the budget would not be balanced and it could result in a spike in US yields.

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