It has been nearly 8 weeks that Rupee has been caught within a very low volatile range against the US Dollar. It has oscillated between 66.10 and 66.90 on spot, with most of the trading confined to an even shallower range of 66.30-66.70 levels, just 40 paise or 0.6%, over 50 days. I have talked about how historically the month of May generally sees a greater volatility in the currency pair. However, it is hard to find any definite trend across the world financial markets and even commodity markets. Therefore, though I remain of the view that US Dollar can scale higher levels against the Rupee in the coming weeks, but it is hard to say when that breakout in volatility may occur. No major central bank policies are scheduled till the monetary policy meeting of the US Fed. Indian monetary policy meeting is not expected to deliver any fireworks and none of the other major central banks too are expected to act this month. Therefore, the trigger has to be something that is not anticipated or expected, which would be the one that shifts volatility to a higher plane.
I have talked about the importance of “narratives” when understanding direction of asset prices in the financial markets. Yes it will appear complex to most and that has nothing to do with lack or abundance of knowledge of this part of our world. It is reflection that how artificial the process of price discovery has become. If I try and focus just on fundamental driver to understand markets and even forecast markets, I may be at sea most of the time. The narratives in financial markets is about how effective is the central bank’s control over the asset markets. Global economy continues to drag along in a low growth plane, a phase which can be marked as the weakest recovery post world war 2. Many pundits have tried explaining that using factors like high debt, low productivity and even technological displacement of work forces. In my opinion, the answer is a mix of all the three above and along with that the fact that central banks are overdoing everything, the rebalancing process could be getting prolonged. The easy money from the central banks could be keeping unwanted (zombie) enterprises alive, which in turn is leading to an unnecessary competition in the resource markets, where limited resources are being squandered by these dead men walking. If a forest accumulates too much of dead/dry wood and leaves and shrubs, risk of a major forest fire increase, a painful but necessary process by which nature then cleans out the forest for fresh afforestation.
I have narrowed the narrative down to a framework called central bank policy convergence or central bank policy divergence. I have talked about these terms a number of times over the past 2 years. When there is central bank policy convergence, US central bank moves in sync with the perennial dovishness (bias of keeping cost of money lower and supply higher) of the other major western central banks. This lets the US Dollar fall against Asian and European currencies. Chinese Yuan, being softly pegged to the US Dollar, also depreciates against the currencies in Asia and Europe. This leads to market fearing less about the Chinese economy and the financial system, leading to rally in the oil and commodity prices (they also move inversely to the US Dollar), that spills over into the rally in the broad emerging market space and also in the US risky assets. This is what occurred since mid-February, when US central bank talked down the prospect of hiking rates.
We do not want to see opposite of monetary policy convergence, which is monetary policy divergence. During this phase, like it occurred last year. US central sounds hawkish ( bias to make money costly to borrow and supply restricted) in such a case, a polar opposite to the dovishness of the other major developed world central banks. This causes, US Dollar to strengthen, oil and other commodities to fall. China is forced to devalue its soft peg against the US Dollar to avoid being pulled higher against European and Asian currencies. This leads to fear about the Chinese economy and the financial system. That leads to sell-off in the emerging markets stocks, bonds and currencies and also in the developed world risky assets. Therefore, it is important to understand this narrative. One can say now, we need to become better predictor of central bank positioning and hence currencies, if we are going to be on top of the trends in other asset classes.
Take a look at the US economy, which saw some major economic data being released. The first quarter productivity, which is a reflection of efficiency in the economy, was released and it was dismal. Productivity is basically a reflection of how much output the economy derives from per unit of input. Higher the growth in productivity, greater is the wealth of individuals on average in that country. The more you can produce, the more income you can generate, assuming everything else in constant. Nonfarm productivity remained weak in the first quarter, falling at a 1.0 percent annualized pace.
Nonfarm productivity has risen at a slow 0.6 percent pace over the past year. Unless working age population and employed persons are increasing a reasonable pace, slow productivity growth would keep economic growth or GDP growth weak. It is arithmetic, is it not? If per person output is growing very slowly and number of people engaged in the output too is stagnant or growing very slowly, GDP growth, which would be a function of the product of the two, will also be growing at a snail pace. Therefore, the ongoing slow productivity growth has been a key component of the frustratingly slow recovery during this cycle in the US.
In good news from the US economy, the industry surveys done by ISM on manufacturing and services sector companies have shown an uptick in their sentiments over the month of April. Infact, when one takes into account various other measures of the industrial activity in the economy and same for the services sector, latter stands out stronger. As a result, employment generation in the US economy has come mostly from the services sector, in terms of rate of growth from each sector. Talking about jobs in the US economy, one will be surprised if one considers how financial markets and currencies reacted to a below average growth in the headlines jobs data for the month of April. In April, US economy added approx. 160,000 jobs, much lower than expectation of 200,000. Initially US Dollar was dumped, commodities and bullion and equities were pumped higher. However, by the close of US session, US Dollar bounced back very strongly and commodities, except for oil came under pressure. Oil and equities held their ground. The trend, like I was saying before is broken and very nuclear right now across the financial assets landscape, including currencies.
One of the reasons why the market did not worry too much about the lower trend data was of the fact that hourly earnings or wages growth picked up to 2.5% without adjusting for the effect of inflation. Remember, in US Fed’s measure of inflationary pressures in the economy, they pay a lot of attention to wage growth. One of the reasons behind the tightening labor market despite slower real GDP growth relative to previous expansions could be the slower productivity growth, as now in the economy in order to produce more output, one needs to hire more people and even pay them more. This also means that inflation is likely to rise, despite real GDP growth of only around two percent, if firms try to maintain margins.