What is left in FX kitty in 2020

The fragility in Forex valuation never tends to remain certain either pre-pandemic or in the midst of great pause. At the outset, the article will broadly breakdown the main levers of Rupee and tentative projections after the US election and later part outlined key important factors for the dollar future path. Indian Rupee has outperformed its Asian peer amid risk appetite has substantially increased in emerging markets driven by record-low interest rates in the developed world which we have widely known as the carry effect. The biggest trigger on the rupee up-move came from the latest tweaks of the RBI Governor’s statement over the comfort of rupee appreciation to curb the imported inflation and subsequently Rupee has risen from 74.50 to nearly 72.85 on the spot market. However, since Brent is consistently trading below $50, imported oil inflation won’t be any major headwind for the Indian economy in upcoming quarters. In-fact expectations of good monsoon may cool-off the headline CPI which recently shot way above RBI’s upper range bound trajectory to 6.69% in August. Ironically appreciation in Rupee won’t pass-through any major improvement in inflation trajectory. According to RBI estimates suggest that over 5% appreciation in the Rupee helped hardly 0.3% in headline CPI figures. Additionally, strong equity inflows over Rs 90,000 crores in the month of August itself along with various Private Equity flows pushed the dollar on back-foot in Indian currency exchanges and the foreign flows will remain in-tact apparently in India barring any major drop doesn’t take place in global equities space. Looking at economic fall-out and concerns over rising Covid 19 cases in India which may push policymakers to bring more stimulus on the table and subsequently fiscal health may take a toll in the coming months. Additionally, extreme expansion of the budget deficit may lead to sharp outflows in the debt market and modest sell-off in the domestic currency unit as well. Apparently, Rupee should face deep resistance around 72.00 on spot and later may decline further amid high volatility in global markets notably ahead of the US election on November 3rd.

Going forward broad dollar move will be guided by three important phases in the next six months. Firstly, the US election. To connect the US Dollar or how global markets will react with the outcome of the US election may sound upheaval of speculation but after GFC (Global Financial Crisis) markets participants are becoming smarter day by day to absorb any abrupt moves. Before moving further, let re-look about the present metrics of winning probability of Biden vs Trump. The best resource to remains on the better edge is realclearpolitics.com and accordingly, Biden is leading with few points especially from swing states (Florida, Michigan, Arizona, North Carolina, Wisconsin, Pennsylvania) and Kamla Harris to be nominated for VP ( Democrats) may sound cheerful for emerging markets but her role may get a boost after the election if Democrats take over. Ironically Kamla Harris represents California, a Democrats influenced state, and may not bring much help to Biden in large six swing states as mentioned above. Again, if Biden comes but that may not guarantee soft foreign policies. Indeed, he may not be an easy candidate for China to deal with but yes Democrats may grip well with its allies especially with its European counterparts. On the flip side, Trump may take the advantage of the partial success in the phase I deal with China. However Chinese purchase of US goods still below 5.5% from last year and less than 1% of US GDP and it looks impossible to enhance the volumes in the midst of a pandemic. What Trump may opt for is non-tariff measures like the current ban over Tik-Tok or place sanctions to Chinese companies operating in the US which will be more harmful to financial markets. Relatively on a modest basis, the US Dollar may find bid, either way, whosoever be the next President. Inevitably Trump will keep the following protectionism while Biden will be less protectionist.

Secondly, the broad rally in emerging currencies notably in the Asian emerging packs came from lower US yield. The shift in real yield in the US relative to major economies kept the dollar under extreme pressure and fell more than two years low to sub 91 – The Dollar Index which is a basket weighted index of six major currencies. At the same time nominal yield in developed markets have been pretty stable and interestingly the gap between nominal and real yield has risen faster in the US than any developed markets which somehow prompted Federal Reserve to announce average inflation targeting which gives more room for inflation to shoot beyond 2% while keeping rates low. Accordingly, the dollar took the hit amid the Fed stance to remain dovish in the rate markets. Going forward the FX volatility may get reduce if ECB (European Central Bank) follows the Federal Reserve path but this would happen only after the review of the average inflation targeting mechanism later next year by FOMC members. Having said that despite any further shift in US real yield take place, that to be far smaller than currently anticipated which may warrant the intensity of fall in the dollar. Albeit the shift in real yields is not the sole factor to drive the dollar but relative US real yields and US Dollar are closely correlated in the last five decades.

Lastly from the Brexit front which turns out to be a huge stopover ahead of the US election finally returning as the FX market was under-priced the Brexit risk since the pandemic hits the global economies. Intriguingly UK Prime Minister Boris Johnson is approaching to bring legislation that would reverse the much of the deal it reached with the EU last year over border issues between Northern Ireland and the Republic of Ireland – which is a part of the EU. Accordingly, the pound fell sharply from 1.33 to sink below 1.30 in dollar term in a matter of two trading sessions. Admittedly how the border between Northern Ireland and Republic Ireland be treated after Brexit is the sole concern in the deal. Moreover, it was Boris Johnson only who stepped forward last October to fix the matter with his Irish counterpart Leo Varadhkar and fortunately the discussion enabled a negotiated statement. Now, any issue which dents the border cooperation across Ireland leads to hard Brexit which implies the UK may leave with the dreaded no-deal. The subsequent reaction will be ugly in sterling as well as in emerging currencies as well. The UK and EU need to negotiate a new trade deal by 31st December 2020 to warrant the steep decline in sterling which looks a bit shaky at this moment. Without a deal, the UK will go back to the base terms of the WTO which means the British economy will face a sharp loss of trade competitiveness as the EU holds for a far greater share of exports to the UK than vice-versa which gives the EU an extra negotiating hand. While Boris Johnson is resetting October 15 as a deadline as mentioned in its latest official note but kept open to undo some of its latest tweaks subject to how the EU negotiators put things in order. As far as FX market is concerned, the worst case in the pound for no-deal exit would be around $1.15 which can push Dollar Index or USD/INR to much higher levels from the current scenario.