The long dollar trade around the globe underwent some interesting twist and turns over the past 12 months. A Trump elevation as President, caused momentary panic in the FX market, as the King Dollar dropped fast, due to possible political risk. However, the narrative changed swiftly as focus was a Republican President with majority in Congress and Senate would drive the deficit higher, causing inflation and growth to pick up steam. Long bond yields in surged in US, along with surge in stocks and so did the US Dollar. Nothing much changed on ground, not even the Trump rhetoric, which remained highly critical of opponents and high on promises. Long Dollar train became just too overcrowded and then came the train wreck.
Since February of this year, Dollar has depreciated between 5%-20%, against major currencies around the world. It has become 8 straight months of dollar decline. We were lucky to change our view early, from a bull on Greenback to being a bear, in the month of February. We focused on Trump politics as a major reason why that can happen. Since, then not much has been achieved by the Trump administration on any of the promised fronts: tax, healthcare, infrastructure and trade. Over the same time, the global policy theme too underwent a significant change, one from monetary policy divergence to monetary policy convergence. Readers would recall that during first half of 2014, we began talking about a “monetary policy divergence” as a theme that would continue to drive US Dollar higher. A higher US Dollar would be negative for global growth as EMs, with disproportionate share of global growth, will face double squeeze from stronger USD and lower commodities. At around the same time we turned a bear on Chinese Yuan too as a stronger USD would compel Chinese Yuan to devalue. Devaluation of commodities and devaluation of Yuan occurred as expected.
In the regime of monetary policy divergence, US central bank was the only major central bank, pursuing tightening of monetary policies, with other major central banks, still on the path of easing. It became a vicious cycle, as strong USD and weak commodities and turbulent stock markets, pulled down global growth and made other central banks even more committed on the path of easing, as they feared deflation and recession. Three good years, the trade worked well. During that same time, period, Rupee started to come out of its multi-year bear run, as sound policies were being put in place by Government and RBI. Not many participants noticed, that Rupee had become one of the strongest currencies after US Dollar during 2014-2016.
Over the past eight months, the emergent theme, monetary policy convergence is about other central banks around the globe now following on the footsteps of the US central bank. The new narrative is fast becoming a virtuous cycle for the world economy. Unlike the erstwhile theme of monetary policy divergence, convergence drives money flow away from USD into other growth seeking currencies, like EMs. This is causing USD to weaken and commodities to rise. Central banks no more fear a deflationary shock causing deep recession, they now turn attention from ultra-lose monetary support of QE and NIRP towards conventional monetary support of lower rates. This adds further fuel to the fire to the short USD, Long EMs and Long commodities trade. The benefits of an EM resurgence flows to developed world too, like Europe. Add to that the receding waves of anti-Euro sentiments (which tends to correlate well with economic hardships. Folks tend to fight more, when going gets tough) and you have a recovery in Euro zone too. ECB not wanting to be left behind has already tapered the pace of purchases from 80 billion euros a month to 60 billion euros. They are expected to taper it further down to zero over the next 18/24 months.
In an insightful article Bryce Coward, CFA describes how global PMI tends to lead the global stock markets. According to investopedia, “the Purchasing Managers’ Index (PMI) is an indicator of the economic health of the manufacturing and services sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. The purpose of the PMI is to provide information about current business conditions to company decision makers, analysts and purchasing managers.”
Once we combine the previous two charts with the two opposing regimes of monetary policies, we get a pictorial representation of the impact on business sentiments and financial markets.
The above chart is a representation of the way positions have flipped in the foreign exchange market. From being records shorts on the Euro, now traders are record long. This is not just for the Euro, but almost all major currencies around the world against the US Dollar, except for the Yen or CHF. One can A glance at the chart can make contrarian voices sound alarm at the record longs in the Euro now or record shorts in US Dollar now. We agree, on a short to medium term basis, the bearish camp in the USD is becoming overcrowded and hence there is a possibility of a squeeze. What can trigger a rally in USD? It can be some constructive policies from Trump on Tax and infrastructure. However, though we are concerned with the record bearish sentiments in the US Dollar for the near term. However, we believe, the upcoming rally in US Dollar will be a bear market correction, which can last for a few months. Once the correction ends, the downward trend in US Dollar can re-assert itself. We expect Trump administration to continue to undermine the US Dollar and that would remain the case for most of his term in office.
From world let us turn our attention back home. GDP growth slowed to lowest levels since 2015. It is not just GDP, leading and co-incident economic indicators had all indicated a slowdown in economic activity. Though the slowdown in concerning but it is not unexpected. Indian government, laudably remains committed on a path of:
1) Greater transparency in business and commerce
2) Higher probity in public service.
It has implemented several measures to reduce corruption and eradicate unaccounted income and wealth. They have been taking the steps since coming to power in 2014. Back then we highlighted the fact that such steps are much needed but will extract a medium term economic cost. The informal sector and the corrupt sectors of the economy are the hardest hit. However, it is necessary to contain the malice of ‘black’ money and corruption.
We are not in the camp that believes there is a structural downturn in the economy. We expect consumption to rebound. Multi-pronged attack on NPA mess would help revive investment. Though private investments are expected to remain muted but they will continue to show a gradual pick-up in coming quarters as business community adjusts to a post GST and post demonetized world. A strong global growth will continue to boost exports and RBI remains committed to keep CAD at a check, which means drag on GDP from external sector will remain low in the coming quarters. We expect government spending growth to hold up. All in all, we can see GDP growth rebound strongly by over 300 bps on a nominal basis.
With growth expected to rebound and inflation remaining benign, we see little danger to the macro outlook of Rupee. Remember the R-G-P framework to analyse the internal dynamics of a nation’s currency. R-G-P framework stands for outlook on relative real rates, growth and politics.
RBI having committed its monetary policy to positive and high real rates have faced a lot of criticism from the certain section of the intelligentsia. Though the debate on real rates would continue. However, we believe RBI has been unfairly and erroneously criticized for their FX policy. RBI Governor Urjit Patel has done a fabulous job of keeping the Rupee from appreciating like other EM and DM currencies have done against USD. There is a hue and cry going around, that RBI has allowed Rupee to appreciate, which hurting India’s external sector. The truth is completely different. Check the two graphs, depicting how Rupee faired against major global currencies YTD in 2017.
Where is the data that Rupee has become one of the strongest currencies in 2017? It has not only unperformed its EM peers but also lost ground against 9 of the 11 currencies in the developed block. Critics need to do a fact check. At the same time, we need to be more empathetic to RBI. RBI has faced the most challenging environment since demonetisation and US elections. They have not only got the currency circulation back on its feet in record time, they also managed to stabilise the money markets. At a time, when USD collapsed against other currencies, RBI has stood like a wall and absorbed the capital inflows, so that the current account deficit does not balloon and Rupee does not strengthen too much. India was fortunate to have Dr. Rajan as our governor and his contribution to policy making will always be remembered as he left after a glorious innings at RBI. However, it our belief that there is a risk that we may be giving credit where there is none due, when we say, that Dr. Rajan managed to keep the currency reasonably weak, but RBI, under Dr. Patel and others have failed to do so. Nothing can be further than the truth. A simple use of WCRS function of Bloomberg will clear the myth.
Between 2014 and 2016, though Indian Rupee depreciated from 62 to 68.00 levels against the US Dollar. However, we should not forget that during the same time, US Dollar rallied anywhere between 15%-50% against almost all of the major currencies globally. Therefore, on a relative basis, we strengthened against almost all the other currencies, except for the US Dollar. If there was ever a talk of external sector being harmed due to currency strength, it should have been then and not now.
We have explained in our previous columns, how many economist and non-economist tend to confuse trade and capital flows. That confuse causes enormous misdiagnosis and wrong prescriptions as policy advice. In modern world, capital flows drive trade and current account can be termed as a balancing figure. It is a left over from the capital inflows outside central bank and capital outflows triggered by central banks through FX intervention. If a country receives massive amount of capital inflows, due to strong macro story, like India has and also due to favourable global factors, then it is up to a central bank, how much they decide to mop up in their reserves. Rest will show as a current account deficit. The lesser the mop-up, higher the current account deficit and stronger the currency against its peers. A stronger currency has it winners as well as losers. We should refrain from painting economic effects with too large a brush. For example, a stronger currency, increases disposable income of citizens, esp the ones who earn their livelihood from non-tradable sector, for example part of the services, which can help boost consumption. A strong currency is negative for the tradable sector.
We hope, policymakers continue to pursue the sound monetary and fiscal policies as they are doing now. Hence, we remain bullish on Rupee for the medium to long term. Though corrective phases in stock markets can trigger temporary devaluations in the Rupee for example say towards 64.50 or 65.00 but we would advise exporters and carry traders to utilise such devaluation phases to go long the Rupee as over the long term we can see the Rupee trading below 60.00.