Federal Reserve’s hawkish stance during 2018 has been one of the primary reason behind USD strength. We saw dollar index move from 90 to 96, EURUSD move from 1.24 to 1.13 and USDINR move from 63.50 to 74.50. Now at the beginning of the 2019, the stance has changed dramatically and significantly. From an earlier expectation of 3 hikes in 2019, now market is expecting not even a single hike. There is a modest probability of 20% for a single rate hike and interestingly 7% for a rate cut. The manner in which Powell reacted to Dow fall shows that they are willing to go extra mile to keep markets stable and will not hesitate much before cutting the rates as well. The recent slowdown warnings from IMF, Chinese export slowdown will help Fed to be dovish.
The dovish stance means weakness for dollar. This is a big big driver of global liquidity and primary reason behind dollar direction. By this logic alone USDINR should be moving towards sub 70.0 levels.
However there are factors which can change this relationship.
With US unemployment at historic low of around 3.7%-3.9%, it is only the inflation which is providing leeway to Fed for being dovish. Any increase in US inflation will be forcing Fed to think of rate hike given the history and success of Volcker period.
If “Trade War” between US and China is resolved in favour of US, which is more likely, that will boost US GDP and hence will push Fed towards rate hike and hence dollar positive. In any case China importing more from US means more demand for USD.
Fed’s balance sheet reduction seems to have garnered lesser attention that it deserved. The last Fed meeting put the focus back on this issue, with Powell clarifying that the balance sheet adjustment is on an auto-pilot mode. If QE has pushed up markets all these years, it is only logical that withdrawing liquidity elicits an opposite reaction. This is the first time after 2008 that the combined balance sheet of the Fed, ECB, and BOJ has reduced in size. The Y-o-Y change in the G3 central balance sheet has turned negative now and this fact would have repercussions for market liquidity in 2019.
Broadly we expect that, while the Fed would try hard for a soft-landing of the US economy, the task will not be easy given it is the 10th year of an economic bull cycle driven by significant liquidity. To add to the Fed’s woes are evidences of global slowdown in economic activities as suggested by slowing Chinese exports, lowered IMF growth projection, poor German growth numbers. An overly pessimistic global growth scenario will create risk aversion even if Fed is supportive with liquidity. Risk aversion is specifically negative for emerging market currencies like INR.
However, if Fed can pull through a soft landing of US economy with stable global markets, then INR may benefit from carry trade and see stability for a while though domestic factors like LS election will keep INR volatile and under pressure.
Even if Fed manages a soft-landing for the US economy, Emerging Markets with high Current Account Deficit (CAD), including India, might be at the receiving end because of their CAD funding dependencies on global flows and Dollar liquidity. This is subject to Brent being over 80.0 levels which will make CAD for India unsustainable
Overall we expect that Fed’s dovish stance is big positive for INR and should push it to sub 70 and 69 levels however factors which can derail Fed’s support and take INR to 75-76 are – a) Indian LS election b) Brent at 80+ levels c) Global risk aversion driven by slow down or any other factors d) US inflation uptick showing up