Today’s story appears to be different, and, if equity volatility continues to climb, we could see currencies and gold unstable for a longer period, as they were back in 2008
The volatility of the Dow (48.9% and rising) has more or less reached the peak it did back in 2008 (51.7%). Intra-day volatility is huge, with the market going from gains to losses to gains, vice versa, or some other combination every day. This reminds me of one of my early market lessons from Guru #1 (Daddy), which was that when intra-day volatility goes crazy, the market is very close to a big move. This also makes intuitive sense: if the market doesn’t know what to do, one day it will just scream loudly and move dramatically. In most cases, this is a signal for a much lower market, which would not surprise anyone in the current environment.
Interestingly, the volatility of global currency markets and gold, while high (and climbing), are nowhere near the levels seen in 2008; rather they are approaching the levels seen in 2013, during the taper tantrum. The volatility of gold was over 40% in 2008 and around 28% in 2013; it is 22% today; so, too, the volatility of the dollar index was over 16% in 2008 and around 10% in 2013; it is about 8.5% today.
This means that the taper tantrum was largely a currency play, with investors pulling back from non-USD assets, but with limited impact on US equities. Today’s story appears to be different, and, if equity volatility continues to climb, we could see currencies and gold unstable for a longer period, as they were back in 2008. Several professional analysts are looking for a long/sharp decline in the dollar; my sense is that, whatever happens, it will be a volatile road.
The rupee, too, has become more volatile, but the rise (to about 7.5%) is miles away from its 2013 peak of over 18%. It is clear that since Shaktikanta Das came in as RBI Governor (December 2018), the policy of reserves accumulation has continued, and it has shown reasonable success at preventing rupee appreciation. As the reserves continue to balloon, markets may show increasing respect in terms of not going too aggressively against the rupee, particularly as RBI has shown that it is willing to intervene even in the off-shore market. Of course, if (when?) global equity markets turn, the reserves will only serve to stem the volatility, but will not do too much for the decline.
It is also important to recognise that there is a significant cost to holding reserve USD assets. They have to be funded with rupees at a net cost of around 4-5%. With reserves at $500 bn, the cost would be $20-25 bn (or more than Rs 1.5 lakh crore), reducing RBI’s profits dramatically. Thus, reserves accumulation will also have its limits. Indeed, if, by some unlikely twist of fate, the risk-on sentiment in global markets sustains, or even increases, RBI will at some point be compelled to back away from this policy to protect its accounts even if it means the rupee ends up appreciating.
Nonetheless, while the rupee has been holding steady for nearly three months, it is worth noting that the rupee rallies (such as they are) seldom, if ever, enable it to rise above its previous all-time low, which in the current case was Rs 74.45 hit way back in October 2018. This suggests that the upside is limited, and with forward costs at less than 4% pa for 12 months, it would appear prudent for companies with short USD positions to increase their hedges at spot levels around Rs 75.50.
Of course, it is more likely that the next big move in the rupee will be downwards (weaker rupee), depending on when (rather than how) the balance between fundamental nervousness in global equity markets (prices are too high, the re-opening of economies has been difficult, nobody knows how the pandemic will really play out, and, of course, Trump) and the impossibility of not buying assets when money is virtually free (the FOMO—fear of missing out—strategy of investment) breaks. The sharp increase in intra-day volatility over the past few weeks suggests that this denouement may not be far off.
Thus, the opportunity to risk ratio for exporters favours staying unhedged, since the decline would likely be much higher than premium foregone. On the other hand, simply waiting for the storm to hit is not always the best approach—I would point out that the export rate for July (and subsequent months) has lost nearly two rupees since the low hit back in April. In absolute terms, that is a loss of 3%! The bird in hand approach calls for a certain minimum hedge at all points in time to avoid premium decay. Given the tenuousness with which markets are holding on, hedge ratios could be relatively low (say, between 30 and 40%), but should be enhanced at every 50 paise to one rupee favourable move.