Falling US Dollar, Flattening US yield curve and an unabated rally in equities is a phenomenon we have got used to in the past nine months ever since thereflation trades fizzled out. Global Equities have continued to rally, unfazed by geopolitical tensions in Korea and the Middle East, rate hikes and balance sheet reduction by the US Federal Reserve, political turmoil in Spain, political stalemate in Germany, concerns over high debt levels in China. The markets seem to have taken all negative news in its stride.
The euphoria, however, is not completely unjustified as Global growth has been the strongest in many years. The Purchasing Manager’s Index (PMI) is higher than 50 (indicating expansion) in more than 90% of the major economies worldwide for the first time since 2011. It is also for the first time in many years that major global central banks are moving in unison towards gradually withdrawing the unprecedented monetary policy measures that have been in place since the great financial crisis. Monetary policy divergence between the US and rest of the major economies was the primary reason for US Dollar strength. The convergence in monetary polices is therefore negative for the US Dollar. The economic data surprises (actual data versus consensus expectations) from the UK, Eurozone and Japan have been positive whereas US data has been consistently missing estimates off late. The US Federal Reserve has also played its part in communicating its policy stance effectively and preparing the markets beforehand for impending rate hikes and balance sheet reduction. This has ensured that rollback of stimulus does not spook markets. Inability of the Trump administration to push through reforms has also put a lid on the US Dollar and US yields.
Amid a weaker US Dollar globally and buoyed by Moody’s upgrade of India’s sovereign rating last week, the sentiment in Rupee has again turned around (which had been temporarily soured by concerns over rising current account deficit due to falling exports and rising global crude prices). November has seen the strongest inflows into equities since March (close to USD 3Bn) and FPI inflows into the domestic debt markets have continued for the eleventh straight month. This is also the first instance since March that equity has outperformed debt in terms of FPI inflows. Since the upgrade, the Rupee has appreciated from 65.30 to 64.35. Near term outlook on the Rupee is likely to be shaped by four factors. First, the US term premium; There is a strong correlation between US term premium and ADXY (index for basket of Asian currencies). The US yield curve could steepen if US tax reforms get through and this could be a major negative for EM currencies. In addition to deficit funded tax reform (if it gets through), higher defense spending and hurricane related expenses would also increase supply of US treasuries next year. This could lift longer-term rates, especially as the Federal Reserve would no longer be rolling over its maturing holdings. Second, fiscal slippage; Uncertainty around the indirect tax collections could result in government missing its fiscal deficit target of 3.2% for this financial year. Third, global crude prices; the OPEC would most likely extend production cuts till late 2018 but this is already factored in the price to a great extent. However, a spike in WTI above USD 60 per barrel would ring alarm bells on the current account front. Fourth; Gujarat Elections outcome; Though the BJP is likely to emerge victorious, the markets will keep an eye on the final tally of seats. If the BJP gets less than 105 seats, it could possibly trigger a sell off in domestic stocks and bonds. The RBI is likely to maintain status quo in its policy on 6thDecember and the US Federal Reserve is almost certain to hike the overnight Fed funds rate by 25bps in its policy on 13th December. If the Rupee appreciates in line with Asian and Emerging market currencies, we would see limited intervention from the central bank. 64.35 was the breakout zone and would be a very crucial support. Break and close below 64.35 could open room for further down side.
It would be difficult for the ECB to ignore the pick up in growth in Eurozone and therefore its commentary is likely to turn more hawkish from hereon. Trimming of asset purchases is likely to push yields in Eurozone higher especially for peripheral bonds. The deadlock in Germany could end with announcement of reelection and that could possibly strengthen the position of the right wing nationalist party, AFD. The Euro could come under pressure in that scenario. A minority government of CDU/CSU and the Greens with outside support from the FDP is an option but it would be a weak coalition.
The Sterling would continue to be driven by Brexit related headlines. The UK and EU are close to an agreement on the divorce bill and this could open doors for trade negotiations. This is a positive development and could prop up Sterling. 1.3150 would be an extremely crucial support on the down side.
