After a protracted phase of low volatility, USD/INR broke through the key resistance at 64.35 last week due to a combination of global and domestic factors. Rupee saw the biggest weekly decline in 11 months and it was one of the worst performing Emerging Market (EM) currencies in this period. The move was not entirely unexpected as the short positioning in USD/INR was overstretched both onshore as well as offshore and an unwinding of carry trade was on the cards.
On the global front, the US Federal Reserve dot plot indicated that twelve out of sixteen members are expecting a 25bps rate hike by the end of 2017. The probability of a December hike has risen to 63% from 38% a week ago. The US Federal Reserve also announced that the process of reduction of its balance sheet would get underway in October. This has pushed the US yields higher and has caused the US Dollar to strengthen especially against the EM currencies. One needs to closely track the US yields and difference between the 10y and 2y US yields. As the yields head higher and the 10s-2s spread widens (indicating rise in inflation expectation and steepening of yield curve), it could push the US Dollar higher especially against Asian and EM currencies. The tax plan to be unveiled by the Trump administration on 25th September could also be a trigger for US yields. The tax plan could likely outline tax cuts that both Democrats and Republicans agree on and this enhances the likelihood of it passing through the Congress. The US government has averted a shutdown by postponing the Debt ceiling to December but the concerns could reemerge towards end of this year.
On the Domestic front, macroeconomic factors seem to be tilting against the Rupee.Widening trade deficit owing to sharper pick up in imports (on account demonetization and GST supply shock) than exports and concerns over the government meeting its fiscal deficit target for the year could weigh on the Rupee. There is uncertainty around center’s indirect tax collections due to transition to GST and if additional fiscal measures are introduced to support growth, it could weigh adversely on domestic yields which in turn could spook FPIs that have invested heavily in Indian government bonds this year. A large part of the move in the Rupee in the last week could be attributed to offshore unwinding. The 1M onshore-offshore spread which was around 4-6p until last week was -4p this week indicating tremendous unwinding of offshore carry positions. It will be interesting to see what is the stance of central bank when there is pressure on the Rupee to depreciate. When Rupee was appreciating, the central bank intervened and sought to keep Rupee in line with other Asian currencies. By doing so it has bolstered its reserves (USD 403Bn now).
The central bank, therefore, has the cushion of reserves to prevent Rupee from depreciating this time around unlike in 2013. It also has the option of intervening through the exchange traded currency futures market. The central bank will have to strike a delicate balance between ensuring the export competitiveness of rupee (due to Rupee strength) and inflationary pressure (due to Rupee weakness).
To conclude, the risks to USD/INR stemming from global and domestic factors are skewed to the up side. While 64.35 would be a key support on the down side, levels of 65.50 and 66.00 could be seen in 4-6 months time frame. Geopolitical developments in the Korean peninsula need to be closely followed as it could prove to be a trigger for a sudden spike in USD/INR if tensions escalate further.
The author is CEO, IFA Global
Disclaimer: Views expressed are personal. They do not reflect the view/s of Business Standard.