From an age of monetary policy divergence, we have moved to monetary policy convergence. Back in summer of 2014, I started to write about how divergent monetary policies can play havoc in currency and other asset markets. Then the US Fed had embarked on tapering of its QE program from USD 85 billion a month and asset managers and borrowers had begun moving out of USD as a source of funding to currencies like Euro and Yen. BoJ was in the second year of easing and ECB was making noises about their own QE too. I then wrote, that the differing path of monetary policies meant that USD can strengthen significantly. A strong dollar, along with a slowing Chinese economy could knock the wind out of commodities. Collateral damage from strong USD and weak commodities will be on the nations who were overly dependent on expensive commodities for their livelihood and cheap USD for their funding.
For three good years policy divergence rocked all boats. Indian economy benefitted, as our dependence on commodities and USD was not as pervasive as other EMs. Additionally, a political change in India ensured that political tailwinds began supporting the economy. However, not every part of the Indian economy was a winner. The non-urban, commodity and real estate dependent part was not be able to reap the dividends of this new economic/financial cycle. Therefore, it came as no surprise to me, that farmer protests have become a burning issue in 2017. However, it is unfortunate that farm distress is being blamed on the current administration, when it is the fallout of ineffective policies of the previous governments and the change in economic/financial cycle, away from hard assets towards financial assets.
In 2017, the theme has changed. Back in February, when we turned bearish on US Dollar, we banked on politics and positioning to support our call. We opined that former, would be more structural than latter. Since then, USD has weakened between 5/10 percent, depending on which currency you are using to judge the performance. Positioning has flipped, as traders have switched from being uber bulls to being bears on the Dollar. Therefore, being short US Dollar is no longer a contrarian bet, it is part of a consensus play right now. Having said that, I would urge you to probe the market sentiment more deeply. Underneath the dollar bearishness, I am pretty confident, you will still find the belief that the three year run in USD has only taken a pause. As a result, the camp which believes that US Dollar has entered a more structural bear market, as opposed to a tactical correction or pause, is not so crowded. Therefore, from a strategic standpoint, there is enough meat left to enjoy if you are a strategic USD bear. Along the way, we will witness the fair share of deep corrective rise in US Dollar and that will be the opportune moment to express the positional short view in the Greenback.
In the opening sentence I wrote about monetary policy convergence. Under this new theme, major central banks around the world are either at the final laps of their easing policies or may have begun the journey of monetary tightening, like the US Fed. There is a convergence in the direction of monetary policies around the world. Therefore, market adjustment in yields and currencies resulting from a gradual reversal in the policies of the other major central banks in DM and EM economies, like, ECB, BoE and BoC and RBI and PBoC would be greater than that of a timid continuation in the policy of the Fed. Strategic trends in currencies are born out of three major factors: Real rates, Growth and Politics. I call it the R-G-P framework. R-G-P framework has to be used in the light of relativity and in an ex-ante manner. Like a beauty contest, we need to compare the expected scenarios of R-G-P in one currency with those of the other currency. My R-G-P framework is intended to remove the confusion surrounding currency markets. In my opinion, currency market is the easiest of financial markets to understand and trade but it is also the most misunderstood. Anybody without a proper framework to navigate the tons of data would be left overwhelmed. The R-G-P framework offers you the lens through which to understand the primary dynamics at play in any currency pair.
The R-G-P framework helped us go against the consensus back in February and turn bullish on INR against the US Dollar. Then RBI had just changed its stance on monetary policy from being dovish to neutral. GOI was focused on reforms to lower deficits and improving the quality of fiscal expenditure. Two together, signaled that inflation expectation would remain low and real rates high. High real rates is a major attraction for any currency, in this case, the Rupee. Next was growth, thanks to the reforms from GOI and efforts to clean up the banking system to corporate balance sheet, growth prospect looked promising. Additionally, political stability in India meant that Rupee was on the path to glory. However, the picture was not complete unless we did a comparison with what was happening in America. There, real rates were not so attractive, as inflation was well above short term rates on USD. Growth prospects were turning less promising, as Trump administration began being jammed by members of his own party and opposition. Politics was never supposed to be a hallmark of America, under Trump presidency, as volatile president maketh a volatile presidency. Trump was more focused on trade skirmishes, which if history is any guide, is a huge negative for the US Dollar.
Going ahead, we expect politics would continue to undermine the US Dollar and over the long term, we can see USD weaken not just against the Indian Rupee but also against other major currencies. In My opinion, we may have begun a multi-year decline in the US Dollar. A weak USD, though is positive for commodities but in our opinion, global economic dynamic, would keep a lid on industrial commodity prices. However, it could be agri-commodities which could score the biggest gains.
Before I conclude, let me touch upon the short term view on key currencies and markets. Rupee is unable to gain past 64.20 levels against USD on spot, as RBI is determined to defend the US Dollar with its dear life. As a result, fresh shorts on USD may have to wait for levels closer to 64.70/65.00 on spot. Euro can test 1.18/1.19 over the near term, from where a strong correction can be seen. However, the primary trend remains upward for Euro and it can continue to strengthen against USD, GBP and JPY. We favour a strategic long pay on Euro on sharp decline, against GBP and JPY, as UK is mired in Brexit weakness and Japan remains pressed on easing. Indian bonds are in a bull market and any sharp decline in prices are a buying opportunity.
NOTE: The views are those of the author and not of Financial Express Online