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Axis of Volatility: Rise of Trump, Qe-Clief & Fed’s Reputational risk

Over the week, Dollar/Rupee made a sharp U-turn as rumours of “policy driven” devaluation made rounds in media circles.

By: | Updated: September 19, 2016 11:44 AM
Indian government is looking to make Masala Bonds popular. In this case it is the foreign investor who assumes the currency risk as the instrument is issued in local currency. (PTI) Indian government is looking to make Masala Bonds popular. In this case it is the foreign investor who assumes the currency risk as the instrument is issued in local currency. (PTI)

Over the week, Dollar/Rupee made a sharp U-turn as rumours of “policy driven” devaluation made rounds in media circles.

We find little substance in the news as Rupee remains a market driven exchange rate, and unlike currencies which are pegged, like Chinese Yuan, it is not easy to devalue or appreciate a currency as per the whims and fancies of the policymakers. At most a central bank can intervene in the FX market and buy US Dollars to devalue the Rupee for some time but unless market forces are convinced it will be hard to maintain the currency on that path for a longer time frame.

At the same time here are the reasons why we believe India would not adopt a relatively weaker exchange policy:

1) Import intensity of our exports have increased over the years. A weaker currency would also have an adverse impact on our exports which have import intensity.

2) Indian government is looking to make Masala Bonds popular. In this case it is the foreign investor who assumes the currency risk as the instrument is issued in local currency. If Rupee begins to depreciate sharply then foreigners may start demanding a higher coupon on these bonds which cause issuers to shy away.

3) India needs a stable currency to allow foreign investors to pour long term money into India. A weak currency is detrimental to such flows.

4) Indian economy is supply constrained making it inherently inflationary. Too weak a currency can cause inflation to rise. Higher inflation would lead to exodus of foreign capital into our bond market and impair the investments of the banks who are already strained

5) Indian government can face geo-political flak if it adopts currency devaluation as an overt policy.

Though induced devaluation appears remote but risk for market driven devaluation is rising. There are number of factors over the horizon that can cause Rupee to fall against dollar. One is the US fed, following that are political events in Europe surrounding Italian referendum and last but not the least US Presidential elections and what effect it has on China. Add to that the fact market is sensing a “QE cliff”- inability of Eurozone and Japanese central bankers to be able to continue and expand their monetary easing program either due to lack of supply of government bonds or even political opposition.

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Bank of Japan will take to stage this week. After a long time, a lot is expected from the central bank. However, the central bank has their back to the wall.

They already own more than a third of the outstanding government bonds in Japan and if they continue to buy at the rate of 80 trillion Yen of bonds every year, then over next two years, the share may rise north of 60%.

Their annual run rate of purchases is nearly double the annual pace of new issuance of long term government bonds. With the supply of available long term government bonds drying up, BoJ may find it difficult to continue this pace of purchases beyond another 12 months.

At the same time, BoJ is already owning over 60% of the AUM of ETFs in Japan. The corporate bond market is small in Japan. Therefore, there is not much large scale assets which BoJ can use to increase its existing QE. Remember, pushing rates to negative or buying ETFs does not have a much of negative impact on Yen.

Therefore, the question remains, will BoJ be able to take a more drastic action as buying foreign bonds or hint at helicopter money.

However, there is a lot of talk going on about a reverse operation twist, where they sell long term bonds and buy short term bonds. The objective would be too steepen yield curve and help banks in their earnings.

However, there are adverse implication of a bear steeping of yield curve, as it can be seen a monetary tightening, causing Yen to appreciate even more.

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Source: Barclays

The predicament of QE cliff is not just facing the BoJ but the European Central Bank as well. ECB has promised to buy Euro 80 billion a month of bonds under its QE program, however, they have also set sub-limits on how much of bonds of each Euro zone nation it can buy.

The limit is as per the economic share of each nation with an overall cap of 33% of each countries outstanding issued debt. At the same time, it has committed to buy debt in the 2-30 year bucket yielding more than the negative 0.4%, the rate on its deposit facility.

As a result, it is German and French bonds which end up being the biggest share of their portfolio. It is being widely speculated that ECB may run out of German bonds to buy before end of this year or mid of next year, thereby threatening the extension of the QE program beyond March 2017 (take a look at the graphic compiled by the team from Barclays).

At the same time, there is stiff opposition from Bundesbank and German financial industry as they see the current monetary policy causing harm to German banks, pension funds and insurance industry as negative yields and flat yield curve is making business difficult.

Some German politicians have even blamed ECB’s policy in fueling the rise of anti-Euro sentiments in the nation.

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On one hand when markets are slowly warming up to the risk of a “QE cliff”, on the other they are watching nervously the rising popularity of Mr. Donald Trump in the opinion polls.

The above chart plots his numbers on opinion polls and S&P 500. There is a visible inverse correlation between the two time series.

We need to keep a tab on this. Recently Mr. Trump made headlines when he openly criticized US Fed for keeping rates lower and hurting US consumers.

He even alleged that Fed is a political institution and rates are lower due to the willingness of the existing President.

He even hinted that rates may rise sharply once the new President comes to power, hinting at himself. We believe, Mr. Trump’s rise would increase the risk in various dimensions.

From Central banking to trade with China and even other geo-political relationships, which would be negative for risk assets world over.

Over the past week, interestingly, inspite of the early weakness post weak macroeconomic data points, US Dollar has bounced against most currencies.

It is important when markets fail to respond to a barrage of bearish developments, like weak jobs data, weak consumer spending and weak industrial sentiment surveys.

It means something is happening underneath the surface that is shaping the trend of the markets, and which is not visible to naked eye.

The question is what it might be? Would US Fed go for a rate hike in September, odds are low but if they do, then it can come as a negative shock to markets. There can be two reasons why US Fed may opt for a hike in September:

1) To protect their reputation, that has been badly bruised, evident from the growing apathy of general public and intelligentsia towards central bankers and their easy money policies

2) To engineer a correction in asset prices to temper the excessive speculative frenzy currently underway, which if not culled, can snow ball into such a bubble that can threaten financial stability.

Therefore the possible scenarios and its effect on asset prices can be outlined as follows:

1) US Fed does not hike in September as consensus but gives out a clear hawkish guidance and strong hint for a move in December: It will be seen as positive for US Dollar

2) US Fed does not hike and offers no major hawkish signals: Unlikely, but if it happens, it will be seen as negative for US Dollar.

3) US Fed hikes in September but sugar coats it with no immediate plans to hike in near future: Positive for US Dollar but the rally may not last beyond a few weeks

4) US Fed not only hikes in September but maintains a hawkish stance on future rate hikes: Unlikely, but if it happens, it will be most positive for US Dollar and quite negative for emerging markets

We would attach greater probability to 1 and 3 scenarios.

In Global markets, the interplay of strong USD, weak bonds and weak oil prices is a bad narrative for emerging markets. The longer this play continues, the more vulnerable emerging markets can become. We need to keep an eye on it.

Back home, RBI FX reserves saw another lumpy jump by $3.51 billion to $371.27 billion. It seems most of the increase can be attributed to the fact that RBI has started taking delivery against their long USD positions in the USDINR forward market.

RBI bought these forwards in 2014 to hedge against the outflows from FCNRB scheduled from this month. Over the next 3 months we can see major variations in RBI FX reserves as maturity of FX forwards position related inflow counteracts with FCNRB related outflow.

Over the near term, we see USDINR remaining well supported around 66.60/70 levels on spot and the pair needs to make a sustained move above 67.30 to trigger a short squeeze in USD shorts.

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