This week, it was supposed to be calm and quiet in the global currency markets and so it was. However, we saw the US dollar extend its up move against most currencies, including the Indian rupee. Global economic data slate was short but heavy with GDP prints from US and UK and barrage of economic releases from Japan.
Over the week, rupee lost further ground against the US dollar, as early gains towards 63.00 handle was met with rising demand for hedges from the PSU oilers as well as due to US dollar short covering from the FIIs. Rupee closed the week around 63.66/67 levels on spot in the onshore market. Liquidity was thin, as yearend holidays ensured that large speculative bets remain absent. In fact, illiquid nature of the market might have aggravated the depreciation of the rupee, as few large bids were enough to move the market by 10/15 paise. We can see the illiquid conditions continue for another couple of weeks, especially in the offshore centers.
Globally, traders are increasingly becoming less sanguine to short the US dollar against any other currency, no matter how high the yield or low the country risk premium. US economy clocked a growth of 5% in Q3’2014, highest in a decade. However, to enable an orange to orange comparison, we need to clarify that US calculates GDP growth not on a year on year basis but on quarter on quarter basis, which is then annualized by product of 4. On a y/y basis, US economy grew 2.7% in Q3, highest since Q4 2013, when it grew at 3.1%. However, this does not take away the fact that the overall economic performance of US remains impressive. For an economy which is nearly 9/10 times the sizes of ours, for it to grow at an average rate of 2.5-3% means, they are able to add nearly a quarter of the entire Indian economy every year. This makes it slightly more difficult for emerging market (EM) countries like India to attract foreign money on a relative basis.
US economic growth was broad based in Q3. Private consumption grew 2.7% y/y, thanks to an 8% y/y growth in durable goods consumption. Private investment clocked an impressive run rate of 5.4%, in spite of the slowdown in residential construction, which de-grew by 0.7%. The sharp uptick in non-residential investment is an indication of robust business investment environment. Exports clocked a growth of 3.8%, in the top quartile of growth since 2009, and imports too rose 3.4%. We are yet to see any meaningful of impact of a strong US dollar on US exports, which means that it is one less impediment in the path of the bull market in the US dollar. Government spending was meager 0.3% during third quarter, so a stingy federal government is no longer acting as a headwind for the US economy. All in all it appears that US economic growth continues to power ahead, which creates a strong platform under the US dollar uptrend.
Next year we believe a bigger debate will rage in the financial markets as to whether US economy has managed to attain enough of an escape velocity, for the US fed to consider changing its stance on the interest rates. We see profound impact of that debate on the US Dollar vis a vis Asian and EM currencies and also on the EM equity and debt markets. History has shown us that whenever the US Fed has reversed policy gear, especially after a long pause, emerging market assets prices as well their currencies, along with commodities have witnessed immense increase in volatility. In fact, with vast amount of unhedged US Dollar liabilities on the books of many EM private and public sector, risk of an economic/financial market disruption remains for the emerging markets. However, we believe that US Fed will try and delay as much as possible the rate hike for the fear of financial market disruption. It is a well debated topic that easy money from the Fed has created a spectacular speculative bull markets financial instruments. Hence, when this life support is removed, it would not be surprising if there is seizure in the global asset markets.
Let us delve a little deeper in the US economic story to understand the risk of a “rate hike” driven US dollar frenzy. Dr Raghuram Rajan in his recent speech, has alluded to the risk of sharper interest rate hiking cycle in US, similar on the lines of 1994-95. He said, that in case the US capacity utilization gets stretched and wage growth picks up further steam, inflation fears can cause the US Fed to embark on a far more hawkish rate path. Currently US industrial capacity utilization is running around 80.1%, not very far from peak utlitsation it achieved during 2003-2007 boom of 80.8%. US wage growth is picking up. US core inflation, which strips out the effect of food and energy prices, are rising at close to 2%. In 2004, when US Fed started hiking rates, barring wage growth most of the other measures were on similar levels. However, we have to also consider the fact that global growth engine is in a far more precarious condition and which is supposed to have some negative rub-off on the US economy. At the same time, ongoing commodity deflation cycle will have adverse impact on the US shale boom as some of the oil shale states face weaker employment trends. But there is also a positive side to global commodity deflation, it is the buoyancy that it brings in the disposable income of non-commodity linked consumers in the US economy. We have to wait and watch the resultant impact of the downswing in petroleum prices on the US economy. However, it seems that it might not be strong enough a factor to subdue to the growing clamour of stronger US economy propelling stronger US Dollar.
In the light of all these, EM currencies need to be watched, as macro risks are growing. Though Indian economy has less of macro-economic and political headwinds, than last year, but during times of global risk aversion, there is a risk of contagion. Indian Rupee remains a slave of global risk sentiments and domestic macro theme and many a times it has been observed that former has overshadowed the latter. Therefore, we would urge corporates with US Dollar liability or obligation to tread carefully during the first half of 2015. Dips on the US Dollar towards 62.00/62.50 can be utilized to minimise your currency risks, so that in event of an adverse outcome, a sharp Rupee devaluation, P&L and balance sheets are protected.
In non-US economic news, UK’s current account deficit surged to a record level of 6% of GDP in Q3. CAD grew despite a slight contraction in merchandise trade deficit and was primarily on account of higher net outflow of income proceeds. A ballooning CAD makes GBP vulnerable to external shocks, as slowdown in investment flows can trigger a sharp devaluation of Pound. In other UK economic news, spending by households drove Britain’s economic recovery once again in the third quarter despite a slight fall in disposable incomes and weaker business investment growth than previously reported. The economy grew by 0.7 percent in the July-September period from the second quarter, in line with a previous estimate and slowing only a bit from a revised 0.8 percent between April and June. On a year on year comparison, growth was revised down to 2.6 percent from a previous reading of 3.0 percent. Household real disposable income fell 0.1 percent on the quarter and was up only 1.0 percent on the year, reflecting weak pay growth.
In Japan nominal wages contracted in November, household spending fell, core inflation ex-sales tax hike slowed further and industrial production contracted. However, employment situation improved as jobs available to applicant ratio rose to a highest level in two decades. Overall, Abenomics, is coming at a significant adverse cost to domestic economy and hence we would not be surprised if Japanese govt announces fiscal stimulus soon. Since its economic bust in the late eighties, Japan has used the tools of fiscal stimulation and easy money injection, but that has failed to get the economy out of a secular stagnation. However, since 2012 they have repackaged the old wine in new bottle but with significantly large dose of fizz. Government finances are in precarious condition but that might not deter the existing government to try all possible short term tricks to prop up the economy. In 2015 we expect to see a mix of deficit spending, rising debt ratios and debt monetisation in Japan, which can make Yen a dangerous currency to own.
Next week, Indian Rupee is expected to trade in a narrow band. We see strong support between 62.90/63.10 on spot and resistance closer to 64.00 handles on spot. In case of a dip below 62.90, we expect a drop towards 62.20/40 zone. At the same time, a sustained move above 64.10/20 levels, can expose 65.00/65.50 levels on spot. Bias remains of a stronger US Dollar and hence, sharp declines can be bought into with proper stop losses. Key event to watch out for will remain the Greek Presidential elections, where a defeat of the candidate from the ruling coalition can trigger fresh national elections, which if happens, can lead to an episode of risk aversion in the financial markets.
By Anindya Banerjee, analyst, Kotak Securities