Expect Fed to tighten rates further: BNP Paribas

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The US Federal Reserve has kept the benchmark federal funds rate unchanged at 2%. Holding interest rates steady, the FOMC (Federal Open Market Committee) focused more on the growing risk of inflation. It was the first time the Fed has held rates steady at a policy-setting session since embarking on a series of rate reductions in September.

 

Sharada Selvanathan , Currency Strategist, BNP Paribas said the Fed has spoken quite hawkishly over the last 2-3 weeks. "It is a matter of time that the Fed is going to act to basically support the hawkishness. There is an extremely high risk that the Fed would take away some of the emergency cuts it provided at the very height of the financial crisis."

 

She observed that dollar will start strengthening from here and the rest of the year is going to see more of a dollar rebound than seen over the last six months.

 

Excerpts from CNBC-TV18's exclusive interview with Sharada Selvanathan:

 

Q: Would you say that the FOMC has surprised by being less hawkish than the market thought? How are you approaching the FOMC statements and its future action?

 

A: They did talk about inflation to an extent. They definitely showed that they were concerned about inflation and inflation expectations. They mentioned in the statement that there was a risk that both inflation and its expectations could move higher.

 

But there was one point in the statement that is the less hawkish component. That is when the Fed said that it expected inflation to moderate this year as well as next year. So, the statement basically did not give away any clues as to when the Fed would hike. There were no clues whether they would do that in the coming months.

 

So, with that we did see the market carrying back its rate hike expectations. For instance, the August meeting had seen the market price-in about 30% chance of a rate hike and now that has come down to as low as 6%. So, the probabilities have come down. With that, we are seeing the dollar a little bit weaker.

 

Q: What is the call in terms of what the Fed might do over the next 6-8 months?

 

A: Even though the market has reacted this way, the rest of this year is going to see the dollar rebound. The Fed has already spoken quite hawkishly over the last 2-3 weeks. It is a matter of time that the Fed is going to have to act to basically support the hawkishness.

 

There is an extremely high risk that the Fed would take away some of the emergency cuts that it provided at the very height of the financial crisis. You will see a few steps in that direction some time this year.

 

As that comes through, we will see the dollar start strengthening from here. So, the rest of this year is going to see more of a dollar rebound than we have seen over the last six months.

 

Q: What levels are you looking at for the euro-dollar and the dollar-yen, or even the Swiss Francs?

 

A: For the euro-dollar, I think that 1.60 is going to be a peak. It may even see a move back towards 1.60. We are suggesting to our clients to use any kind of rallies with the 1.58 level to actually form short positions.

 

In terms of dollar-yen, we are likely to see a move towards 110. Even in terms of the dollar-Swiss, which has been actually trading in an extremely tight range, there definitely is room for the dollar-Swiss to break higher.

 

These currencies are still low yielding to some extent. The Japanese, for instance, are big buyers of US treasuries or other assets that have higher yields. As we do see bond yields in the US moving higher, there is an extremely high chance for these low-yielding currencies to underperform. That is a similar reason why I do think the Swiss will continue to underperform against the dollar in the next six months.

 

Q: How do you look at the Indian currency? We have had a huge rate hike coming from the RBI and a cash reserve hike. How are you looking at the currency and the rate scenario in India?

 

A: The rate moves have definitely been a step in the right direction by the RBI. With inflation at 11%, there is little choice for the RBI but to be aggressive at this point. Even with interest rates at 8.5%, real rates are in the negative. So, there really is significant room for the RBI to increase rates further if they want to control inflation.

 

It is important for the RBI to control inflation. Otherwise, they are going to be faced with a serious credibility problem. If they have a credibility issue, then we are going to see significant capital outflows from India. So, we are going to see further rate hikes. It is just whether the RBI is willing to be aggressive enough and really hike rates significantly and also the cash reserve requirement.

 

But in terms of the Indian rupee, the credibility of the RBI is going to be crucial. If the RBI continues to move in the direction it has moved this month, then I do think we are going to see a little bit more support coming into the INR. But if they are going to take their time in controlling inflation, there is definitely going to be further bad news for Indian assets and the INR in the medium-term.