Most of the major risk events – G20 summit, Opec meet, RBI rate decision, state election results – are now behind us. But the factor that has probably had the biggest impact on the rupee was the surprise resignation of RBI governor Urjit Patel. That’s probably because the outcome of the other events had already been factored in. The surprise resignation highlights the friction between the Reserve Bank of India (RBI) and the government and the optics of it all would have definitely spooked FPIs.
However, the appointment of the new governor and his interaction with the media would have eased nerves and restored confidence to some extent.
The global growth outlook and risk sentiment is likely to set the overall tone for domestic assets and the rupee in the medium term. But the degree to which we outperform or underperform would depend on how well RBI and the government manage the domestic challenges.
Outlook on global risk sentiment
The health of the US economy and the Federal Reserve policy would be the key for emerging economies (EM) economies. Recent economic data from the US has been showing signs of a slowdown. Though unemployment rate and jobless claims are at their lowest in half a century, housing sector data and construction spending have been disappointing. Business fixed investment that was robust in the first half of the year also seems to be tapering off as indicated by fall in durable goods orders.
Overall factory orders too fell for the third time in four months pointing to strain in the manufacturing sector. The weak data has caused the markets to revise its trajectory for rate hikes in 2019. The 2s5s segment of the curve has already inverted and breakevens have collapsed. (An inverted yield curve is seen as a sign of an imminent recession). The market is now barely pricing in one hike by the Fed in 2019, down from 2-3 hikes a couple of months ago.
While the US Fed is almost certain to hike rates by 25bps in its December policy, the FOMC members’ economic projections and dot plot would shed further light on growth and inflation expectations and trajectory of hikes. While a slowdown in the US rate hike cycle is good news for EM assets, a slowdown in the US economy would not be. Therefore, one needs to closely monitor the incoming US data; especially housing data, manufacturing PMIs and factory orders to ascertain if the recent weakness is transitory or persistent. If no progress is made during the 90-day timeframe agreed to between the US and China, tariff hikes would kick in and that would certainly dampen business confidence.
Besides the US rates, how crude prices behave will be crucial for EM economies like India. Crude prices have not reacted much despite Opec+ agreeing on a production cut of 1.2 mbpd. If the global demand continues to remain resilient, crude prices could inch higher as the effect of production cut kicks in. But below $70 per barrel (Brent), the elasticity of the rupee to crude prices is expected to remain low. An environment of steady global growth and stable crude prices would be ideal for Indian assets.
Other peripheral developments that have the potential to manifest as bigger risk factors on the global front include the ongoing Mueller investigation into US president Donald Trump’s campaign’s collusion with Russia, the US debt ceiling and risk of partial government shutdown, the US-Saudi diplomatic ties (in the wake of journalist Jamal Khashoggi’s murder and conflict with Houthis in Yemen), Italy’s budget showdown with EU and developments around Brexit.
Outlook on domestic factors
On the domestic front, the recent data has been encouraging after a disappointing July-September quarter. The October IIP growth came in at a 11-month high. Leading indicators like PMIs are also pointing towards a pick-up in growth momentum and revival in business confidence. Inflation as measured by CPI was the lowest in 17 months in November. It was the seventh consecutive month of a downward surprise, making a compelling case for the MPC to change its policy stance back to neutral from that of calibrated tightening. But before it does so it would have to assess whether the food inflation that is in negative territory currently is likely to continue to remain subdued going forward given the low acreage of Rabi crops this time. Besides rate setting, the central bank also has its work cut out in terms of addressing banking system liquidity, fate of PCA banks and stress in the NBFC sector, which are also points of contention with the government.
In its December monetary policy, RBI indicated that it was committed to providing liquidity through further OMOs if necessary and this led to a rally in the bond market with the benchmark 10-year bond yield hitting a low of 7.36 per cent.
The government would have to address concerns of the farm sector in the lead-up to the general elections as it was evident that agriculture distress did play a major role in swaying state election results against it. The government decision of hiking MSPs doesn’t seem to be benefiting farmers. Desperate measures like announcement of a loan waiver scheme would certainly not please the bond markets. The bond prices at this stage are distorted due to the aggressive OMOs by RBI and don’t factor in the imminent risks of fiscal slippage. (The fiscal deficit was already 103.9 per cent of budgeted estimate as on October end compared with 96.1 per cent until October end last year).
Over the medium term, until the interim budget, we should see the rupee consolidate in a range. If the US data does not deteriorate further and crude prices remain stable, upside in the dollar/rupee tango could be capped. We saw FPI flows return to domestic equity and debt in November after huge outflows in September and October (The numbers for December so far are also positive for both equity as well as debt). The move lower is expected to be a grind too, as oil companies would look to make the most of this dip in crude prices and the dollar/rupee. The central bank too would be keen to replenish its reserves by intervening through nationalised banks at lower levels. The realised volatility is expected to come off.
Technically, 72.90 is likely to act as a resistance on the upside and 70.30 is expected to be a good support for the dollar/rupee. Break and close above 72.90 could cause the pair to retest its recent high of 74.48. Exporters are advised to cover exposures up to January-end on upticks to 72.40 and 72.90 through forwards. Farther tenor exposures can be covered through risk reversals to retain participation in opportunities that may arise around budget and general elections. Importers are advised to hedge on dips to 70.80 and 70.30.