Volatility is back and it is back with a bang. After an extremely quiet August, where Rupee traded within a very tight range against US Dollar, we are seeing a good bit of two way movement in the pair. A string of weak US economic reports had initially caused reversal in expectation for a Fed hike in September and a result USD had dropped sharply from 67.00 levels to all way down to 66.32 levels on spot. However, the party in Rupee did not last long as strong intervention from RBI and later a sharp reversal in risk assets globally, pushed USDINR back towards 66.70 levels. As we write, offshore traders have taken Rupee towards 66.90/95 levels in NDF. On Friday night, a selling deluge was witnessed in the global markets, for no apparent reason. Though one can attribute the sell-off partly to the spike in odds for a hike on September but the overall odds remain at levels which is not indicative of a hike.
A couple of weeks back we warned about two issues. One seasonality favours a pickup in volatility in the September-October period and US Fed may look to test markets nerve by talking up the prospect for a rate hike. Hiking rates is not a preferred choice of US Fed but they are being forced to talk about it to cull excessive risk taking in financial assets. Fed is worried that too much complacency can foster parabolic upmoves in financial markets, which can later unwind and threaten financial/economic stability. One way to curb the flow of juices is to induce a dose of uncertainty surrounding the US monetary policy.
Over the past few weeks, sharp upmove has occurred in the long term bond yields in Japan and now in European nations as well as of US. In Japan, rumours of “operation reverse twist” is making rounds. Under the program, Japanese central bank would sell long dated bonds in its portfolio and buy short dated bonds with those proceeds. This is being done to circumvent the problem of low supply of long term government bonds. As a result, we have seen a sharp sell-off in long term Japanese government bonds (JGB) and the yield curve has bear steepened. A steeper yield curve though is positive for Japanese financial institutions, which have been badly hurt due to the ongoing negative interest rate policy (NIRP), but would be quite positive for Yen as higher long term yields will improve its appeal amongst money allocators. Bank of Japan has been pinned in the corner as lack of JGBs blunts their QE and rate policy. Yen is no longer moving as per the wishes of BoJ. In 2016 Yen has become the strongest currency in G7 and one of the strongest in Asia. At the same time, traditional carry trade, where speculators used to borrow cheap Yen and convert it to some foreign currency and buy the non-Japanese assets, is no longer working the way it used to. As a result, the relationship between Yen and risk assets have become asymmetric. During upmoves in global risk assets, Yen is unable to depreciate as it used to before but during periods of risk aversion, Yen is able to appreciate. Global risk trends are dependent on the binary event of monetary policy convergence or divergence. Fed is playing the central role in that game. When Fed goes hawkish, markets focus on policy divergence, and as a result, risky assets are sold and US Dollar and Yen is bought. However, when Fed turn a dove, a soft US Dollar environment prevents Yen from depreciating.
Over the past one month, economic momentum has stalled around the globe. A low and stable commodity prices had offered a seasonal bump up in global economic activity, as commodity producer witnessed some recovery in their earnings, from the abyss and global consumer nations were happy to get the benefit of higher real disposable income. However, low commodity prices is like a slow bleed for the commodity producing countries. The longer the prices stay in this range, which is what it is expected to do, the deeper the economic rebalancing these countries and companies will face. It does not matter how low is the operating cost for some of the commodity producers, what matters is that their lifestyle cost remains way above than what the current commodity prices can sustain. As a result, it is no surprising that it is a tale of two cities as far as outlook on manufacturing and services go. Manufacturing is struggling globally, as the sector is most exposed to globalization due to its deep global links. Services on the other hand, is more domestically oriented. At the same time, services tend to be relatively low priced items of consumption than many goods of manufacturing. During times of economic weakness, it is therefore, services which tend to fare better than manufacturing. It is this strength of services sector which is keeping the global economy afloat. At the same time, the ultra-easy monetary policies have aided the economic muddle through in the medium term, though at a cost for the longer term. Easy money has fuelled an asset boom around the globe, in some countries it is only financial like India, and in others it is both hard and financial like US. Higher asset prices have curbed the pain of rebalancing in the corporate sector and also supported consumer sentiments. However, the question remains, for how long can the central banks continue to keep asset prices propped? The longer they do it the more lopsided the structure is becoming, which sometime in future can cause financial/economic instability.
Over the past two days, there has been heavy selling from the short volatility, systematic funds globally. These funds invest in both fixed income securities as well as in stocks. However, their strategies are designed to target volatility in a manner that when volatility is low, allocation to the asset increases. The exceptionally low volatile environment post-Brexit, where various measures of realised volatility had dropped to multi-decade lows, fanned excessive concentration in risky assets. At the same time, these funds thrive during times where bonds and equity are inversely correlated. Therefore, during times when correlation between bonds and equities become positively correlated, these funds suffer. Over the past week, not only has fixed income and stocks become highly correlated but in both volatility has begun to rise. In such an environment, these mega AUM systematic funds would be forced to rebalance their portfolio and shed risk. The more they do that, the higher goes volatility and tighter becomes the correlation, leading to a vicious cycle of selling begets more selling kind of scenario. Therefore, currency traders need to pay close attention to these markets. Indian Rupee is expected to weaken towards 67.10/20 levels on spot, against US Dollar. Technically a break above 67.30 can cause a short USD squeeze. Key support is between 66.60/65 levels, which if broken will expose the previous weeks low of 66.30/32 on spot. Indian Bonds too can face some selling pressure due to the sell-off in global bonds.