Rupee moved between 4-6% against major currencies if one considers December 31st close and first quarter highs and lows. Volatility was exceptionally high across asset classes and currencies as central banks intervened to backstop bleeding risk appetite.
Indian Rupee witnessed one of the most volatile moves during the first quarter of 2016 or final quarter of FY16. Rupee moved between 4-6% against major currencies if one considers December 31st close and first quarter highs and lows. Volatility was exceptionally high across asset classes and currencies as central banks intervened to backstop bleeding risk appetite. It was first Bank of Japan who announced negative interest rates, followed by the European Central Banks who not only reduced deposit rates further into negative territory but also greatly expanded its asset purchase program. US Federal Reserve was not to be left behind as they followed up with very dovish rhetoric which pushed the interest rate hike expectation to mid of next year.
Interestingly all these happened either going into the G-20 meeting in February in China or after that. As if an unofficial truce was declared between major central banks engaged in the currency and the agreement was on the need to move away from the game of competitive policies towards co-ordinated policy framework. Back home, sentiment took a 180 degree reversal post Budget. Any seasoned observer of the market will find the behavior of investor high unstable and dangerous. Going into the Union Budget, investors were gripped in irrational fear; as a result Indian assets were diverging negatively from the world markets. Having priced the Armageddon, post Budget, there was only one way to go, and that was up for the Indian Rupee and the Indian financial asset prices. Foreign investors who had suddenly caught flu towards Indian markets in January and February, was falling over each other to scoop up the same asset at higher prices. We understand that is how sentiments shift but what is shocking is the magnitude of the shift in sentiment over just 90 days. Sentiment moved from neutral to abject fear from December of last year to February of this year and then back to euphoria in just 31 days of March. Forget fundamental, even technical structures do not change in such a short span of time. It is clear case of massive herding in investment, which is alarming.
We have to zoom out of the daily noise of markets to be able to see the big picture. The question we need to ask is why financial markets are getting stressed to often now. They are being saved every time by constant attempt my central banks and policy makers to dominate the narrative. It is a narrative driven financial markets, where there is lack of faith over fundamental drivers and greater addictions towards a fresh narrative from the policy makers. Post 2008, how much of the discussion veers around what central banks can do and will do, rather than anything else. Such a talk has become the top agenda for discussion for retail investors as well as for every kind of institutional investor. Something has definitely gone wrong, when investment has come to punting on central banks. We do not think central bankers too would have imagined it would come to this moment. Policy makers have become like the daredevil stuntman of a circus, where unless he or she ensures more extreme, insane and perilous acts every other time, the audience, in this case asset managers, will become disappointed and desert the risk assets in a herd like fashion.
Let us do that zooming out exercise to understand why we are in this kind of a narrative driven world. Before 2007-08, world economy was witnessing an unprecedented boom, where growth lifted all boats. Rising economic activity was sustained by growing savings and investment imbalance. The imbalance can be understood from the growing current account deficits of the consuming nations financed by the elevated and rising current account surplus of the producers. This symbiotic relationship created a feedback loop that helped private debt levels soar in the developed world, the consumer economies, like US, PIIGS, UK etc. It came to a grinding halt during the debt crises of 2007-08. The ensuing adjustment of that economic imbalance (savings and investment) begun to unfold in three stages.
Stage one saw the debt crises causing debt levels to level off and then slowly roll over. Peak in private debt meant, consumers started to reduce their levels of consumption. It was followed by stage two, which was about the adverse impact on income flows, caused by falling current account balances. Consumers reduced their consumption, which meant lower current account deficits in the consuming nations. Someone’s consumption is someone else’s income, so producer nations saw their current account surpluses contract. In stage two something interesting happened, central banks having studied the previous similar cycle which played out during the 1930s, jumped into the ring to protect the financial institutions and prop up asset prices. They feared that high levels of debt coupled with falling income, mix of stage one and two, can lead to debt write-off, asset liquidations and debt restructuring, the stage three. So they feared a repeat of the long streak of bank failures that occurred during 1930s. Did that intervention change anything? We believe it has only added more petroleum and dry wood to stage three.
Remember, the three step process is a way of economic rebalancing which is needed for the next secular economic up cycle to begin. It is a delicate balance between trying to create shock absorbers and trying to stall and the process altogether to see it return with a bigger force over the near future. Central banks may have done the latter. A way to gauge the maturity of the rebalancing process is to track the current account balances and then the debt levels. Debt levels should finally begin fall quite sharply to complete the rebalancing process. In current environment, though current account balances have adjusted significantly, with debt crises and commodity bust, but debt levels have only increased in the world. Since 2007, the debt crises failed to bring down the debt levels, as policy maker tried to short circuit the process. They have manipulated cost of money to ridiculous levels of zero to negative and then pumped trillions of dollars into the financial system. This propagated a culture of rising indebtedness through various aggressive lending and corporate buybacks. We call those policies as supply side policies. These policies aggravate deflationary forces as they do not allow excess capacities to move out of market, a zombification of the economies.
Let us take the analogy to engine which needs to be regularly cleaned and oiled to perform well. If that car engine is made to run greater distance with lesser and lesser maintenance, it will suffer frequent breakdowns. The global economy and financial markets is like that machine. The growing debt levels are increasing the stress on the engine, the falling income flows (evident from the contracting current account balances) is making it difficult to service that growing debt burden, leading to frequent economic/financial crises. Make no mistake, these occurrences will only increase. Which means we will see more of these sudden and dramatic shifts in sentiments and trend in asset prices, as central banks jumps in with more death defying supply side policies? How long can this continue, we do not know but it shall continue till debt levels begin to fall sharply. The way to achieve that is through paying down of debt, asset liquidation, debt restructuring and debt write-offs.
Investors need to account for the narrative driven market structure in into their wealth management plan. As managers of financial risk:- 1) foreign exchange 2) interest rates we need to factor the implications of the new era. We will have to embrace the fact that we will sudden burst of massive volatilities in rates and fx and also emergence of some strange cross asset and cross currency correlation. It is no longer the simple world, where a rising dollar meant short risk and falling dollar meant long risk.
Managing that risk in Indian Rupee would mean that we can expect central bank to play a key role in ensuring Rupee remains within a wide range against the US Dollar. RBI has already made it quite clear that it will pursue purchase of domestic bonds and also foreign currencies to shore up Rupee liquidity. It is a strong signal that Rupee may not be allowed to trend too much against the US Dollar. Hence, we see a range of 66.00 to 68.00 over the April-June quarter and 66.00 to 67.20 over the next few weeks. However, Rupee may continue to trade weak against non-dollar currencies like Japanese Yen and Euro but remain firm against British Pound. Indian long tenor bonds are expected to remain firm as 10 year yields are expected to remain between 7.30 to 7.60 over the medium term.