Two major events have unfolded over the past twelve days. One, the decision on demonetization and other, election of anti-establishment candidate, Donald Trump. First was a real surprise and second one was low probability outcome. Assets markets have seen volatility rise and Rupee has not been able to remain immune to that. Going into the US elections I had warned, through our research reports, that there was too much complacency in the Dollar/Rupee market. Historical comparisons had shown how, periods of such low volatility, have been followed by sharp rise thereafter. Outflows have picked up over the month of November from Indian financial markets, nearly USD 3 billion have been sold by FPIs in bond and equity markets combined. However, in the sell-off Indian is not being singled out, as more or less almost all emerging markets are facing the same problem. Rising bond yields in US have tightened the offshore US Dollar market, making EMs unattractive for global investors. Add to that the near term economic cost from the demonetization, foreign investors are opting to sell first and ask question later.
However, the same demonitisation has had a major bullish impact on Indian debt market, as yield across the board have dropped. Indian 10 year yield closed around 6.42%, at a multi-year low, USDINR inched towards the Brexit high at 68.22 levels on spot and Nifty inched closer to 8000 levels on cash.
Over the past week, quite a few important economic data was released from China, Europe and America. At the same time, key speeches from central bankers of Eurozone, Japan, UK and US move the currency markets. Yellen’s prepared speech was actually released ahead of her scheduled testimony before the Joint Economic Committee. And it was rather hawkish:
“At our meeting earlier this month, the Committee judged that the case for an increase in the target range had continued to strengthen and that such an increase could well become appropriate relatively soon if incoming data provide some further evidence of continued progress toward the Committee’s objectives”…..“But because monetary policy is only moderately accommodative, the risk of falling behind the curve in the near future appears limited, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.”
The hawkish rhetoric in Yellen’s speech caused the Greenback to start advancing against its rivals. US bond yields too marched higher. US Stock market remained resilient as the narrative of Trump lead reform and infrastructure growth remains the underlying driver.
In Eurozone, minutes of the last ECB meeting revealed that most members are in favour of an extension in the asset purchase program beyond March of next year. There was no surprise in that, but I suspect, we may see tapering in the amount of purchases to be done post March from Euro 80 billion per month to Euro 70/75 billion per month. Such an announcement may add fuel to the fire and push the US Dollar higher against Euro. However, incase ECB decides to not extend QE beyond March 2017, whose probability is low, then Euro can send a shocker down the European debt market. We may see, a perfect storm for European debt, as bond yields would soar, non-financial stocks fall and Euro outperform against every major currency.
The British Pound, after having seen a major bout of volatility post Brexit, is now trading within a quite range against the US Dollar. Traders seems have to lost taste of the news flow on Brexit. Right now the focus in squarely on US and Euro zone. However, that did not prevent the GBP doing some quite to and fro moves against US Dollar and strengthen against Euro. Bank of England has adopted a neutral stance after the economic reports have continued to point towards a stable UK economy. The tradable sector within the UK economy would benefit from the depreciation in GBP. However, current account still remains elevated and there are mounting concerns over how the existing government has navigate the treacherous path towards Brexit. We believe, rest of EU would like to play hardball, a game of chicken, where they do not want to be seen relenting to UK, in case it fans far right sentiments back home. A number of them are facing elections over the next 9/12 months. Hence, I continue with my bearish stance on GBP. I had turned a bear on GBP, post Brexit. High levels of current account deficit, near zero policy rates and risk of hard Brexit would continue to cast a shadow over British Pound in the times to come.
Much of what is happening in mainland Europe can get impacted by what happened in America on 9 th November. World over there has been a rising trend of electing anti-establishment candidates. I had covered this aspect before too, connecting it to history, during 1920/30s and also connecting with the socio-economic backdrop. I believe, Brexit has had an impact on US election and both together may have an impact on political outcomes in Europe. On Sunday 4 December, Austria may well elect a far right President, while Italy could vote no against a constitutional reform – which could lead to the resignation of Italian PM Renzi, with the anti-establishment (and anti-euro) Five-Star Movement standing a fair chance of getting into power at the next general election. In March 2017, the Netherlands is electing a new Parliament. The far-right populist PVV formation of Geert Wilders is leading in the opinion polls. In France, Marine Le Pen, a far right candidate, though may not be able to win the Presidential election but having her impact on election process, where other candidates are taking tough stance towards emigration and EU. Therefore, we can say, that the political volatility that began with Brexit, now has gained momentum after US elections and now threatens to increase further as EU heads to polling stations. Asset markets would have to grapple with that new variable.
Election of Donald Trump has brought in a new narrative. The narrative goes like this. President Trump would look to reduce regulations, lower taxes and spend on building physical infrastructure. The question that we need to ask, how will they fund all of these? Even if they announce some kind of a public-private partnership program to get things, there will be hit to exchequer. Therein lies the secret behind the move in the US bond yields. Expectation is for fiscal deficit and hence debt to rise, which in turn would improve growth and inflation expectation. Higher growth and inflation expectation is causing an upward repricing in the US bond yields. Higher bond yields have caused the offshore borrowing rate for US Dollar, Libor to rise too. Libor is up over 100 bps over past 12 months, partly on account of the new money market rules. However, a higher cost of dollar borrowing and higher dollar is like a monetary tightening shocks for the USD 10 trillion outstanding global dollar denominated debt, as well as for growth in emerging market. This narrative has a lot of potency. It is also expected that President Trump will turn inward, less globalization, to generate and keep demand internally in order to create jobs within America. All these are a perfect storm for the emerging markets, which have benefited from the weak dollar, lower USD yield and more globalized demand from developed world.
Before I conclude let me touch upon the expectation on key currencies and local bond market over the next week. I see the rally in US bond yields continuing further, possibly towards 2.48/2.52% on the 10 year, which means US Dollar would continue to gain ground against emerging market currency like Rupee. As a result, USD INR can touch 68.60/68.80 levels on spot. Indian equity markets can face further selling pressure but Indian bonds would continue to stay resilient on the back of demand from banks. We can expect a range of 7.35/7.50% on the Indian 10 year over the next week. Indian Rupee continue to hold fort against Yen and Euro and GBP.