WORLD MONEY
In our last column (“The Trump trade”, November 20), we highlighted the dramatic changes in market movements brought about by the results of the US elections. The dollar’s sharp rise has been driven by the market’s first-cut reaction to various facets of Donald Trump’s USfirst policy and the fear that emerging markets will bear the brunt of his protectionist policies.
We now focus on how the currency market is likely to behave in the near future after this rally, drawing on a detailed study by HDFC Bank of the dollar’s behaviour over the last six years (“The Trump trade and beyond”, December 2). Is the dollar headed for further gains despite its current “overvaluation” of 14-15 per cent? If the dollar continues its march, will the rupee bust the critical 70 to the dollar level?
The trajectory of the dollar index (a weighted average vis-à-vis its trading partners) shows a strong tendency for it to revert to its mean or underlying trend after a sharp deviation in response to an unexpected event (or a “shock” in economists’ parlance) such as the Trump win. The report identifies four episodes when the dollar index had moved away from its underlying trend — the taper tantrum of 2013 in which there was a prolonged deviation of the dollar from its mean, the Chinese devaluation of August 2015, the Fed rate hike of December 2015 and the period of August-September 2016 when the market anticipated a rate hike but the Fed did not deliver.
This time, the report argues, the dollar is likely to behave like it did in the run-up to the US Fed meeting in December 2015 when the dollar index rose by about three per cent but reverted to its mean in a period of two to three months. A sustained overshoot (a scenario resembling the taper tantrum period) is less likely and could arise in case of such black swan events as disintegration of the European Union or hard landing in China. Given that markets often factor in worst case scenarios, the dollar’s rise has probably been based on the expectation of a runaway fiscal deficit and a steep rise in interest rates. These might not quite pan out the way they currently expect.
For example, a strong dollar and high interest rates are inconsistent with Trump’s agenda of getting industries back to the US. Similarly, an extreme protectionist stance against China and Mexico would entail large costs for US manufacturing in terms of the price of critical inputs that feed US supply chains. Currency markets may, therefore, be pricing in a more aggressive agenda than it would be possible for the Trump administration to pursue in the real world.
Further, the US economic recovery remains tepid despite tightness in the labour market, a rise in consumer confidence and escalating home sales. Inflationary expectations are still contained and the hardening of Treasury yields has already tightened financial conditions. Against this backdrop, a steep hike in policy rates by the Fed may not be warranted and a possible hike in December may be followed by another one only after the middle of 2017.
Unlike the dollar whose recent appreciation has made it overvalued, the rupee was already so and its recent depreciation has brought it closer to its underlying trend. Thus, one can argue that with the recent round of depreciation the rupee is “fairly valued”. During previous shocks such as the Chinese devaluation or the US Fed rate hike last year, the rupee did move a bit, but remained close to its mean, deviating only marginally for short periods of time. This possibly captures the effect of heavy intervention in the markets by the Reserve Bank of India that seems keen to hold the currency in a tight range. India’s fundamentals remain strong and if the dollar rally loses steam over the next few weeks or days the pressure on the rupee to depreciate further could also diminish.
Risks loom on a couple of fronts. If Trump sticks to his campaign script and throws all pragmatism and caution to the winds, the dollar could move deeper into uncharted ground where it keeps gaining weight. Besides, if the domestic economy sees a sustained slowdown on the back of a cash crunch, the rupee could be a casualty. Then all bets on its likely level are off!