India is gradually becoming an oasis for global investors, as the world has become a desert of economies which have seen their growth prospects marked down or have become saddled with debt-deflation or have become prone to sovereign and financial risks.
Rupee, along with domestic debt instruments continue to reflect the shift in India’s positioning. At a time when, emerging market is getting shrouded with the risk of several downgrades, Indian sovereign, quasi-sovereign and even corporate debt papers are finding enough takers.
Rupee has become one of the top performing currencies over the last 12/13 months. One can gauge the true extent of Rupee’s strength from the way the currency has steadily appreciated against whole host of non- US Dollar currencies. Even against the US Dollar, we have not lost ground as much as other EM currencies have. On one hand, Indian economy derives a substantial chunk of growth from domestic sectors and on the other hand we import a sizable chunk of energy and other commodities from abroad. The deflationary bust, which has gripped the hard assets, has benefitted India disproportionately. The longer the bust remains, the greater the fiscal and current account dividend that will flow to us. Capital account has got a boost from chase for yields from global asset managers. At a time, where a chunk of the developed world sovereign interest rates are either at zero or even negative, and equity markets trading at lofty valuations, it is making Indian capital markets quite attractive proposition for the foreign investors.
Foreign investor fancy can sometimes become a double edged sword. The inflows can aggravate financial market cycles so much, that they can become detached from the underlying economy. At the same time, the deeper the importance of foreign portfolio inflows in deciding our domestic financial asset prices, that stronger the risk of collateral damage, during times of global risk aversions. Dr. Rajan, many a times, have talked about this aspect of global capital flows. Hence, it can be said that though we would be cry and dance with the ebb and flow of world speculative mood but as long as the government and the nation continues to take the steps in the right direction, India as an economy will prosper over the longer run. However, as participants and critics we have to be observant of the evolving trends in, both, the asset side as well as the liability side of the Indian sovereign and its corporate sector. As economist Michael Pettis wrote in his blog about balance sheet inversion, a key concept to understand macro and corporate vulnerabilities. In brief, he has highlighted that though reforms and right policies are needed ingredient for productivity growth, which drives asset side improvement of a nation, but it is equally important how that growth is being funded (liability management). In case, the country over time relies too much on short term foreign currency debt and even hot portfolio flows, over stable FDI inflows, then during times of macro-economic stress, which could be triggered by exogenous events, can alter a virtuous economic cycle into a vicious one.
Turning our attention to market movements over the past week, we saw Rupee depreciate against the US Dollar towards 62.05 levels on spot. One can attribute the pop in the Greenback to the hawkish stance of the US Fed in its latest monetary policy. However, that hawkishness has failed to translate into much gains for the US Dollars against the majors. However US Dollar rocked against the EM and commodity bloc currencies. Gold rebounded from its intra-week lows and so did crude oil prices, which surged by nearly 9% from the Friday session lows. 10 year yields in the developed world continue to plumb lower lows on the back of slowing growth and rising deflationary pressures. Back home in India, equity markets corrected from a fresh all-time high, which saw the Nifty almost kiss the 9000 handle. Indian corporates results have been far from encouraging, and such a trend is visible even across the globe, a more reflection of the economic reality. This might have given as excuse to an overbought market to take a pause and correct.
Global economy witnessed some interesting policy maneuvers over the past couple of weeks. On one hand, the European Central Bank finally launched the quantitative easing program, where they announced they will purchase nearly 1.2 trillion euros of sovereign and corporate bonds from the Euro zone financial system. The program requires the national central banks to backstop most of the purchases. Infact, we believe the lack of centralization of bond purchases and minimal risk mutualisation aggravates the disunity within the currency union. Though ECB has announced a negative interest rates on deposits, but that along with QE might not be enough to get the currency Union out of debt deflation and weak growth. In Euro zone, unlike UK or US, local participation in domestic equity markets is much lower, as a result, there is going to be much muted the impact of wealth effect from higher stock prices. At the same time, unless demand improves in Euro zone, pushing more cash into the banking system might not lead to much improvement in lending in periphery or semi-core nations. For Euro zone to move out of the economic and financial rabbit hole, it needs to not only consider a mix of debt cancellation of highly indebted countries, but also look at augmenting demand in core nations. It is practically impossible for non core countries to pay down their debt through deep austerity. Such steps have backfired in a country like Greece, where now a leftist coalition government is threatening to overturn all conditions of Troika. Over the medium to long term, we would keep a close eye on the Euro zone, on how it can engineer a fresh course, as a failure to do so, can escalate political and economic costs.
The hawkish stance of the US fed, where some of the voting as well as non-voting members have alluded to a mid-year rate hike, is hard to digest. When one considers the global and domestic macros economic backdrop, it is very surprising to see US FOMC remain so hawkish.
Though, unemployment rate in US has fallen sharply over the last one year, and is now being forecasted to inch closer to 5% over the remainder of the years, but indicators like falling labour force participation and surge in low paying jobs, puts in doubt the strength of the recovery. At the same time, the developing stress in the North American oil and gas industry, both US Shale sector and Canadian oil sands sector, can take some sheen of the consumption and investment boom in US. Deflation is being imported through a stronger US Dollar and also through rising deflationary pressures in China, Euro zone, Japan and in other parts of the world. A strong US Dollar is also hurting export growth as well as earnings of US corporates. It will be difficult for US to remain immune to a slowing world economy. Therefore, in such a scenario how can one accept a very hawkish US Fed. We believe the reasons could less economic and more financial and philosophical.
Let us discuss three key reasons that could be driving the hawks ahead of doves in the US FOMC:-
1. US fed’s credibility: It may perceive that a shift to dovishness now might endanger their credibility.
2. Providing a long rope to rest of the world: US allowing other countries to devalue their currencies against the US Dollar to provide them with room to benefit from improved export performance and stabilise their economies. However, there is a limit up to which US can ignore a stronger dollar and we believe that time could be running out and hence that “rope” in our opinion, might be reaching its end.
3. To exit from the trap of a “zero rate policy”: A zero rate policy comes with increased macroeconomic costs. Therefore, such policies cannot be continued forever, as eventually, costs will outweigh benefits. We believe US Fed could be seeing the current macro-economic backdrop in the country as an optimum opportunity to wean away financial markets from its own ZIRP policy and towards QE of ECB and Bank of Japan. However, we see this as a delicate step and even as a dangerous ploy. Such a divergent path of monetary policy can expand volatility and tension in the financial markets, which have become over addicted to the US Fed’s accommodation. There is even a risk that, US Fed might end up with a policy miss-step. That can explain the flattening of the US yield curve on the face of the threats of rate hike.
Over the next week, we would keep a close eye on the RBI monetary policy as well as the HSBC services PMI data from India. Market is expecting RBI to stand pat on rates on February and then ease again 75-100 bps over the rest of the year, starting with the meeting post Budget.
From US, the ISM surveys and US jobs data will be key events to watch, along with comments from the US Fed officials. Over the coming months, stance of the US Fed officials will have significant impact on the US Dollar as well as on the global markets. A continued hawkish tone from US Fed can keep the US Dollar buoyant but if that translates into increased risk aversion in financial assets, then it can be also be positive for a carry currency like the Japanese Yen. Technically, Rupee appears to have formed a top around 61.20/30 mark and therefore, it can continue to slide towards 62.25/30 levels. A Fall beyond 62.30 can trigger stop loss selling, which can cause a push towards 62.65/70 levels on spot. Keep an eye on the Yen/ INR, where after months of riding the bear wave we have begun nibbling on the long side. Technically, Yen/INR seems to be forming a base around 51.00/52.00 region on spot, so as long as that holds, we can see a rally towards 54.00/54.50 levels. Much depends on how deeper the global equity markets sink, as S&P 500 and USD/JPY are stuck in a range. Incase both breaks down, especially if USD/JPY breaks below 115.50/115.80 levels on cash, then it can trigger much a bigger rally in Yen/INR and can also mean more stress for EM financial assets. At the same time, a sustained breakout in USD/JPY above 119, can be quite positive for global equities and negative for the Yen/INR.
Anindya Banerjee, Analyst, Kotak Securities