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After a protracted period of carry dominated low volatility, USD/INR sprang to life in the last fortnight, breaking through the crucial resistance of 65.35. The depreciation since has been steep, making Rupee one of the worst performing currencies amongst EMs. Much of this up move was on the back of domestic factors. With broad based USD turnaround also looking likely, macros and technicals are stacked against the Rupee. Now is the right time for treasuries to restratagize and reconsider their hedging options. It is important to be agile to the regime change due to changing macros and avoid getting into the trap of anchoring bias.
The current bout of Rupee weakness does not just seem like a passing phase. The inflation dynamics have changed. India is vulnerable to rising crude prices. The OPEC members have complied with their respective production quotas and inventories have shown marked drawdown. Our exports have not picked up in line with the strength in the global economy. The recent trade deficit on a seasonally adjusted basis was higher than USD 15Bn. At this rate, the current account deficit for FY19 is likely to be around USD 80-90 billion.
While this is significantly higher than USD 20-30 billion seen in recent years, there are concerns over whether the capital inflows would continue that could fund this CAD. FDI inflows too seem to be waning. Lack of confidence in the RBI policy due to recent flip-flops has seen FPIs withdraw USD 2Bn from the debt markets in just a few sessions. With US rates too heading higher, the capital account flows in FY19 are not expected to be anywhere close to what we have seen in recent times. The last time we saw our BoP in this situation, was in 2013 when Rupee had depreciated from 58 to 68 levels within a very short span of time.
Though the RBI has accumulated significant reserves since then, in terms of coverage of our external debt, the ratio continues to remain the same, which is why any escalation in capital flight from EMs can spook the Rupee. There is no reason why we cannot see a repeat of 2008, 2013 kind of a situation. In a scenario of rising US rates and rising domestic inflation, the RBI is expected to hike rates later this year. Current OIS prices are factoring in 2 hikes by end of FY19. Domestic core inflation has been sticky and if inflation surprises further on the up side, the real rate differential between US and India could narrow, resulting in capital flight. The RBI may have to hike rates in order to combat this.
USDINR Weekly chart: (Mid 2007 - Till Date)It has been observed USDINR consolidate before sharp, trending upmove
Technically, the DXY has broken through the key resistance at 90.60 and has broken a weekly trend line. This is pointing towards a reversal in the USD Dollar against majors. On the Rupee, break of 65.35 was a significant break out. The first major resistance that the market was seeing was 66.65-70 (from where the Rupee had gapped down post the UP election results). With that break, there is almost no technical level in sight till the previous high of 68.90. Further higher degree wave will finish its final leg around 70.00 mark.
The spread between offshore and onshore forward points was at its widest in recent times (8-9p) indicating massive unwinding of offshore carry positions. Three-month carry to vol ratio has declined significantly but not as much as is usually seen in times of panic which indicates there could be further strain on the Rupee. The difference between one month and three month ATMF vols has also declined. Flattening of the vol curve has resulted in steep depreciation in the Rupee in the past of the order of 5-6%.
Seasonality chart of Rupee also validate the quote: “Sell in May and Go Away”. Out of past 10 years, Rupee was seen depreciating for 8 times at an average rate of 1.73%. June too has historically been a weak month for Rupee and a rewarding month for USD bulls.
USDINR Seasonality chart: Green color suggests Rupee depreciation and Red color suggests Rupee appreciation
In a nutshell, fundamental factors described exclusively above suggest that there is further room for rupee to depreciate against the US dollar. After breakout above 65.35 levels, we have seen that the USDINR pair is convincingly trading above 2 std. deviation on a weekly basis. There are triggers for the volatility to remain elevated for an extended period of time. The pair can be seen moving further towards its all time high of 68.90 by the end of this year and extension of the bullish leg beyond this level could take the pair higher towards 70 mark by 1st quarter of 2019.
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