US Dollar and the Global Currencies – Correction or Reversal?
It has been a fortnight since Donald Trump got inaugurated. Last week the markets also saw the first FOMC statement and the first Payrolls data since Trump’s inauguration. On the domestic front, we had the union budget for 2018. It is a good time therefore to incorporate the latest developments and review if they alter the medium term outlook on currencies and markets in a significant manner.
The US yields and the Dollar index have defied expectations and moved against the run of play. The Dollar index in fact, has retraced significantly and is back below 100 levels after making a 13 year high of around 103.80. This is despite Trump maintaining his stance on and implementing several reforms pertaining to immigration and trade policy that he had promised on his campaign trail. Strong data from the US has failed to support the US Dollar. The most recent payroll data indicated that the US economy added 227k jobs in the month of January, beating estimates of a 180k increase by a comprehensive margin. The jobless claims have also been hovering close to 40 year lows. The PMI data has also been upbeat. It is therefore a tad difficult to come to terms with the recent US Dollar weakness. I see four major reasons for USD weakness:
- Positioning: The market had been long USD in the run up to Trump’s first press conference and inauguration. What we are seeing now is a buy the rumor sell the news phenomenon. The market seems to be taking some profits off the long USD trades.
- Trump’s comment on a strong US Dollar is hurting the US economy seems to be pushing the US Dollar lower.
- Yield Difference: The difference between the 2 year US and German bond yield which was around 2.10% is back to 1.88%. German bund yields have inched higher as inflation in the Eurozone has shown signs of picking up. The market is also coming to terms with an inevitable, eventual roll back of stimulus by the ECB in a phased manner. Also the yield on the JGBs continues to rise. The 10y JGB is currently yielding 0.10% despite BoJ’s commitment to yield curve control by keeping the 10y yield anchored around 0%. The recovery in German and Japanese yields has taken the steam off the US Dollar rally.
- Absence of hawkish cues from the latest FOMC statement: After the December FOMC meeting, markets had already factored in 3 hikes for 2017 based on the median expectations of rates from the dot plot. The latest FOMC statement seemed devoid of any hawkish rhetoric which has caused the market to become apprehensive about the possibility of 3 rate hikes in 2017
Going forward, the market will closely monitor the comments coming out from the White House and progress around the proposed border tax. The border tax if implemented would bring about a lot of uncertainty for the US Dollar. In theory, the border tax, if imposed makes imports more expensive and non-viable. As imports into the country slow down, the selling pressure on USD subsides, causing the US Dollar to appreciate. If the US Dollar appreciates by an amount equal to the border tax imposed, it would offset any benefit that would result from imposing the border tax. In practice, however it takes a while for the currency to adjust. Also, imposition of border tax would be potentially inflationary which could possibly be the trigger that is required for the 10y US yields to break 2.60% and move towards 3%. Measures such as lowering of corporate taxes would certainly attract business investment back into the US. The US Dollar could therefore strengthen on account of financial inflows chasing higher US yields as well as actual business investment inflows.
Globally, politics has taken center stage. Right wing nationalist leaders are gaining popularity as their restrictive policies protecting domestic interests and promising domestic job creation appeal to a wider cross section of people. Upcoming elections in France and Germany will also be crucial in this regard. We could see elevated uncertainty and a fresh move lower in the Euro towards 1.05 if market senses a rising probability of National Front leader Marine Le Pen coming to power in France.
In terms of levels, 1.0850 on EUR/USD is a major resistance , which most is likely to hold and we might see pressure in the pair. On GBP/USD, 1.2760 is a major resistance and key support lies around 1.2450, break of which would imply the end of the short term uptrend. Yen too seems overbought and 110 should hold.
On the domestic front, the Finance Minister presented the budget for FY2018 in the parliament on 1st February. Contrary to expectations, the government exercised reasonable fiscal prudence. It did not seek leeway on fiscal deficit front, pegging it at 3.2% for FY18 and therefore remains on course to achieve its target of 3% by FY19. The key focus areas of the budget were infrastructure (allocation for infrastructure at Rs 4 Lakh Crore is the highest ever), inclusion (bridging the income inequality) and housing, rural economy, agriculture, MSME. The abolition of FIPB is a step in the right direction and would give a fillip to FDI. Overall it seems to be a budget that would stimulate investment and consumption and foster job creation.
The equity markets reacted extremely positively to the budget and rightly so. The FPIs have been net buyers in equity and debt since budget day, pouring in USD 340Mn in the first three trading sessions of February. The Rupee strengthened against the US Dollar on account of twin factors, global USD weakness and positive sentiment due to a responsible budget.
Technically, it has broken through a crucial support at 67.70, but on the downside 66.80-67.10 is an extremely crucial support zone, where we should see significant interventions by central bank and genuine import buying. The spread between the 1-month onshore and offshore NDF is often a good indicator of sentiment prevailing in USD/INR. The offshore 1M forward points are currently trading at a discount of 6-7p vis-à-vis onshore. One can wait for the spread to narrow before initiating fresh longs. The Rupee strength could continue over the short term. However, over the long term risks are skewed to the upside for the pair. A break of 68.35 this time could result in fresh all time lows for the Rupee. The Rupee continues to remain overvalued by around 18% according to the RBI’s 36-country REER index. Though the index overestimates Rupee overvaluation, even after adjusting for productivity gains, which are typical of a developing economy like India, the Rupee seems to be overvalued by 4-5%.