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Earlier-than-expected QE tapering could potentially redirect money flow from equities towards US bonds

Emerging economies like ours could start to witness a slowdown in capital inflows over the coming months, leading to depreciation of the domestic rupee in the medium term.

June 21, 2021 / 11:43 AM IST

It has been a complete turnaround for the Indian rupee this month (June) as the US Federal Reserve indicated a withdrawal of some of the generous policy responses to the pandemic in its latest meeting.

After appreciating more than 2 percent in April, the Indian rupee has wiped out almost all of the gains clocked last month. The major dent came in as the US Fed delivered a hawkish shift, surprising the Street in a big way and causing disruption to all the asset classes, including the Indian rupee.

In a stark contrast to the earlier view of holding rates near zero till 2023, the Fed's abrupt signal of an accelerated timeline for rate hikes indicates upside risks to the US dollar, going forward, too. The steep rise in the dollar index as a reaction to a more hawkish-than-expected Fed policy meeting triggered the sharp depreciation in the rupee-dollar exchange rate. The dollar index, which tracks the greenback's strength against a basket of major currencies has risen more than 2.0 percent since the announcement. The FOMC fallout in forex markets was quite pronounced as the rupee slid to six-week lows after the news, and was the second-worst hit amongst the Asian currencies.

The Fed has maintained a status-quo on rates and bond-buying program, but the median projection now shows two 25 bsp rate hikes into 2023 amid the economic recovery gathering pace in the US. Besides, even though the Fed has maintained that any inflation is likely to be 'transitory' but inflationary pressures are becoming quite widespread. The higher-than-expected CPI print of 5 percent year-over- year in May, the sharpest increase in nearly three decades is indicating that inflation sting seems to be quite persistent than what Fed is anticipating.

The US economy continues to power ahead amid the continued vaccination drive and fiscal and monetary largesse of the US authorities. Moreover, inflation has been on an upswing amid surging prices of most of the commodities-hard as well as soft due to the rapid increase in the money supply. After months of continuing with their accommodative instance, the Fed had to factor in strong gains expected from the US economy recovering from the pandemic and the impact of loose monetary policy on the rising price pressures.

Close

As the unprecedented monetary policy of the crisis period seems to change, the tailwind to global equities from the continuation of the Fed's accommodative stance being maintained for long could soon start to fade. The timing and pace of interest rate hikes in the US and tapering of its $120 billion per month bond-buying program will be critical for the equities and forex markets alike. Even the quantitative easing (QE) tapering discussion could start earlier-than-expected. It could potentially redirect money flow from equities that are close to record highs towards the US bond markets. Emerging economies like ours could start to witness a slowdown in capital inflows over the coming months, leading to depreciation of the domestic rupee in the medium term.

Another major factor that is weighing on the rupee is the hardening of crude oil prices, wherein they are trading close to two-year highs on the international bourses. This is subsequently leading to a rise in both WPI and CPI on the domestic front. More so, an upward revision in the inflation forecasts is hurting the risk-on sentiments. Additionally, even as forex reserves have surged to record highs of $608 billion, the RBI has indicated that forex reserves are still not adequate and are on a dollar buying spree, leading to pressure on the local unit.

As far as the direction is concerned, the Indian rupee witnessed stiff resistance around the 72.50 mark for the month and has reversed course to witness a brisk slide close to its near-term support at 74.30. The domestic currency could claw back some of the recent losses, as the initial impulse from the Fed's overnight decision subsides. Besides, significant capital flows in the domestic equities, ebbing of the second wave of the pandemic, pick-up in economic activities, and ample liquidity may still support the local unit. Even the Fed officials may try to ease markets nerves with a possible communication intervention pretty soon. However, the medium-term bias has turned negative with the evolving scenario.

Having said that we believe the level of 74.30 will provide some cushion to the Indian rupee in the coming days. Nonetheless, once there is a convincing breach of the 74.30 mark, the setup indicates a move down the line towards 74.90 and then 75.50 eventually.

Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
Sugandha Sachdeva is the Vice President - Commodity & Currency Research at Religare Broking.
first published: Jun 21, 2021 11:43 am

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