Counterintuitive as it may sound, the dollar is fast losing its premium in the future even as it continues to climb against the Indian rupee in the spot foreign exchange market.
The premiums required to book dollars at a future date through the forward contracts market have crashed, especially those with one-year maturity.
The fall isn’t recent but has been in the works since January this year.
However, much of the drop has indeed come in the past four months alone.
One-year forward dollar/rupee premiums are down roughly 100 basis points (bps) in just under four months now. One basis point is equal to one hundredth of a percentage point.
A key reason contributing to the fall in premium is the narrowing interest rate differential between India and the US. Expectations that the Reserve Bank of India (RBI) won’t need to match up the intensity of the US Federal Reserve in rate hikes have strengthened the view that this interest rate differential is set to narrow further in the coming months.
The Fed has hiked its funds rate by 150 bps since June to the current 2.25-2.50 percent and the recent US inflation data for August has cemented expectations of another 75 bps hike at the FOMC meet next week. In fact, some in the domestic foreign exchange market believe there lies a slim chance of a 100 bps hike as well.
Nomura economists expect the Fed to announce a 100 bps hike next week.
“There is no way that the RBI will match up to such large rate hikes because we do not need to respond the same way here. This means that our interest rate differential will come down further. I think, we will see forward premium under pressure in the coming weeks too,” said the general manager of treasury at a public sector bank requesting anonymity.
The RBI’s monetary policy committee is scheduled to meet a week after the Fed’s decision. Although India’s retail inflation has remained above the central bank’s 2-6 percent mandated band, the RBI is expected to announce at best a 50 bps hike in the repo rate. That means the interest rate differential which is currently around 300 bps may narrow to about 250 bps.
A narrowing interest rate differential reduces the benefit of buying dollars in the future. What is adding to the pressure is the growing shortage of dollars in the spot market due to the Fed’s quantitative tightening. Starting this month, the Fed will reduce its balance sheet by $95 billion every month which puts a premium on cash dollars now.
Forex traders believe that both the shrinking interest rate differential and dollar shortage will keep up the pressure on premiums in the short term. Most tenures up to one-year may continue to drop further.
Low premiums are a good event for importers as they may see their cost of booking dollars coming down. At the same time, exporters may suffer some losses on earlier booked contracts. “Such a loss is mostly notional, as there are checks placed, and exporters can always cancel and rebook the contracts to avoid a big hit,” the treasury official quoted above, said.
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