a new normal can be seen in early 2019. This could sound a little far-fetched at this point, but in continuation of our previous report dated April 24, 2018 — where we had underscored the possibility of steep depreciation towards 67.50 & 68.00 levels, we now highlight the key fundamental & technical factors in this report that could trigger the next leg of up move.
After a protracted period of carry dominated by low volatility, USD/INR sprang to life in the last fortnight, breaking through the crucial resistance of 65.35. The depreciation has been steep since then, making rupee one of the worst performing currencies among EMs. Much of this upmove was on the back of domestic factors.
With broad-based USD turnaround also looking likely, macros and technicals are stacked against the rupee. Now is the right time for treasuries to restratagise and reconsider their hedging options. It is important to be agile to the regime change due to changing macros and avoid getting into the trap of anchoring bias.
US President Donald Trump’s decision to re-impose sanctions on Iran will not only hit the dynamics of the global oil trade, it will also force India to revisit at its ties with the Middle Eastern oil nations. The only option as a solution for this is to switch to rupee trade.
In reaction to this, Crude oil (WTI) jumped sharply above USD 72 mark. Uncertainty as to who will form the government in Karnataka is also weighing on the Rupee.
Our exports have not picked up in line with the strength in the global economy. The recent trade deficit on a seasonally adjusted basis was higher than USD 15Bn. At this rate, the current account deficit for FY19 is likely to be around USD 80-90 billion.
While this is significantly higher than USD 20-30 billion seen in recent years, there are concerns over whether the capital inflows would continue that could fund this CAD. FDI inflows, too, seem to be waning.
Lack of confidence in the RBI policy due to recent flip-flops has seen FPIs withdraw USD 2.2 Bn from the debt markets in just a few sessions.
With US rates heading higher, the capital account flows in FY19 are not expected to be anywhere close to what we have seen in recent times. The last time we saw our BoP in this situation, was in 2013 when Rupee had depreciated from 58 to 68 levels within a very short span of time.
Though the RBI has accumulated significant reserves since then, in terms of coverage of our external debt, the ratio continues to remain the same, which is why any escalation in capital flight from EMs can spook the Rupee. There is no reason why we cannot see a repeat of 2008, 2013 kind of a situation. In early of this month, NDF market was seen trading as high as 66.25 after RBI’s move to relax ECB norms and restrictions on FPIs to hold shorter-term government papers.
But after revision in corporate investment holding limit (Capped at 20%) and a stronger dollar, rupee erased all its gains. RBI announced that they will purchase government bonds worth 10,000 crores on 17th May under open market operations (OMO). This will likely soothe the nerves of the G-sec yield as their auction got partly devolved. By doing so it would sterilize the liquidity it would suck out as a result of intervening in FX market to halt rupee depreciation.
In a scenario of rising US rates and rising domestic inflation, the RBI is expected to hike rates later this year. Current OIS prices are factoring in 2 hikes by end of FY19. Domestic core inflation has been sticky and if inflation surprises further on the upside, the real rate differential between US and India could narrow, resulting in capital flight. The RBI may have to hike rates in order to combat this.
Technically, the DXY has broken through the key resistance at 90.60 and has broken a weekly trend line. This is pointing towards a reversal in the USD Dollar against majors. On the Rupee, break of 65.35 was a significant breakout.
The first major resistance that the market was seeing was 66.65-70 (from where the rupee had gapped down post the UP election results). With that break, there is almost no technical level in sight till the previous high of 68.90. Further higher degree wave will finish its final leg around 70.00 mark.
The spread between offshore and onshore forward points was at its widest in recent times (8-9 paise) indicating massive unwinding of offshore carry positions. Three-month carry to vol ratio has declined significantly but not as much as is usually seen in times of panic which indicates there could be a further strain on the Rupee.
The difference between one month and three-month At-the-money forward or ATMF vols has also declined. Flattening of the vol curve has resulted in steep depreciation in the Rupee in the past of the order of 5-6 percent.
Seasonality chart of Rupee also validates the quote: “Sell in May and Go Away”. Out of past 10 years, Rupee was seen depreciating for 8 times at an average rate of 1.73%. June too has historically been a weak month for Rupee and a rewarding month for USD bulls.
It is important to note the above macroeconomic shifts and recalibrate hedging strategy accordingly. Exporters are advised to tread cautiously while availing USD funding as large MTM (in case of steep Rupee depreciation) can result in LER limits being blocked.
In a situation where US interest rates are heading higher and USD/INR too, it is important to manage the risks associated with long-term USD borrowings as well. For receivables/payables, hedging through options can give better flexibility and an opportunity to participate in case Rupee depreciates steeply.
Exporters can consider buying plain vanilla ATMS puts. Though expensive, it can be richly rewarding if Rupee depreciates steeply from here on. Importers are advised to buy Risk reversals i.e. buy ATMS calls and sell OTMS puts or can even consider hedging outright through forwards with a trailing stop loss strategy.
The threat of known unknowns in the form of trade wars and geopolitical risks cannot be overlooked. The imposition of sanctions on Iran by the US could result in a further rally in crude prices.
Escalation of trade tensions between US and China could possibly be a big negative for the global economy. On the domestic front, political drama in Karnataka will be closely tracked. Therefore, the triggers are in place for an extended move up in USD/INR from current levels and it is important to position appropriately to get the most out of this up move.
In a nutshell, fundamental factors described exclusively in above report suggest that there is further room for the rupee to depreciate against the US dollar. After breakout above 65.35 levels, we have seen that the USDINR pair is convincingly trading above 2 std. deviation on a weekly basis. There are triggers for the volatility to remain elevated for an extended period of time.
The pair can be seen moving further towards its all-time high of 68.90 by the end of this year and extension of the bullish leg beyond this level could take the pair higher towards 70 mark by a 1st quarter of 2019.