FX outlook: No radical turning of tide.
The recent hawkish rhetoric of DM central banks has again reminded markets of the impending global financial tightening. But we are far from another taper tantrum and expect low inflation to constrain the pace of DM policy tightening. We do not expect the recent DXY weakening to sustain and expect marginal catch up by late CY2017. EM outlook could turn little hazy amid global uncertainties. Even as INR will likely follow EM directional suit, strong fundamentals will ensure a relatively better performance than the average EM basket. We expect USD/INR to trade in the 64-66.25 range in rest of FY2018, averaging ~65.25.
Markets warming up to DM central banks’ newfound hawkishness
The earlier-than-anticipated turnaround in the DM central banks signaling of policy normalization has led to a global bond sell-off in the past two weeks (Exhibits 1-2). And while moves so far remain trivial by the standards of 2013 and 2015 tantrums, the frequency of such events has risen. While Fed has been telegraphing its intention to shrink its balance sheet, the biggest perceived shift has been in ECB’s reaction function with BoE and BoC also joining the bandwagon. Consequently, the DM yield curves have bear steepened, with Germany in the lead (Exhibit 3). However, JGB yields (and JPY) have seen sharp downward correction after BoJ’s recent fixed rate bond intervention, depicting its intent to decouple from the rest DMs.
Dollar to make a tepid comeback by late CY2017
Despite tighter employment trends, wage and price data continue to disappoint the Fed and ECB. But the confidence of central banks is premised on hopes that sustained solid growth will push inflation higher. We expect a modest inflation recovery and thus see a less steep Fed rate hike path until CY2018 amid balance sheet reduction. While ECB’s newfound hawkishness will help strengthen EUR in the near term, we expect EUR to weaken by 4QFY18, as ECB’s QE taper commences. Further, the net long EUR positions have already reached the highest level since 2011, which could induce a correction (Exhibit 4). Meanwhile, the wider US-Japan interest rate differential will continue to weigh on JPY. Overall, DXY will likely play marginal catch up by late CY2017, after having fallen 7% in CY2017 so far (Exhibit 5).
Muted EM FX outlook
After a spectacular 1HCY17, EM FX outlook is likely to be marred by tightening global financial conditions and geopolitical risks (Exhibit 6). But a well-telegraphed gradual policy normalization by the DMs may limit any widespread EM disruption. On the other hand, the persistence of disinflationary pressures on the back of weak commodity prices is likely to keep the EM central banks’ policy stance focused towards growth-oriented policies. The contrast in the DM and EM monetary policy stances may thus keep the EM currencies on the sidelines.
USD/INR to range 64-66.25 in remainder of FY2018
INR is likely to follow EM suit amid realignment of global risk appetite on the back of DM policy stance. India has witnessed robust FPI flows (~US$22.7 bn in CY2017), heavily tilted towards debt owing to better carry (Exhibit 6), helping keep the INR afloat. However, expectations of narrowing real interest rate differential with the US amid August RBI cut will weigh on FPI debt flows. We revise our FY2018 average USD/INR estimate to 65.25 (66.20 earlier), largely owing to a stronger-than-expected 1QFY18, even as we continue to see INR gradually drift weaker in rest of FY2018. However INR may still outperform most of its EM peers, supported by (1) lower external trade dependence, (2) stronger policy and macro fundamentals and (3) a vigilant RBI.
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