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T.B. Kapali

While the medium-term trend for the rupee is up, there could be short-run fluctuations, which could take the currency away from the medium-term uptrend line.

Chennai June 10

Rising market interest rates reinforced by hawkish central bank comments as well as actual rate hikes (by some central banks) tripped global equity markets in the past week. While US stock markets recovered on Friday, they still ended the week lower. Ditto for most European and Asian stock markets barring the Chinese market, which seems to be stabilising after some regulation-induced knocks in earlier trading sessions.

Indian stock markets also felt the heat of these concerns and both the major market indices were down around 3.50 per cent for the week. The Indian rupee also has backtracked somewhat on the back of these stock market developments and currently at 41.15, is down around 1.50 per cent from its recent highs of 40.40/40.50 against the dollar.

Support could weaken

A study of global central bank policy moves and public comments, movements in market interest rates and in the stock markets, suggests that the interest rate support for global stocks could weaken further in the days ahead. That is, it is possible that interest rates move further (on top of the increases already seen) up to a level which is considered to be in restrictive territory and being capable of affecting earnings performance. It is pertinent to note here that too low interest rates would also not be to the market's liking as that could be interpreted as due to weak economic prospects. While all sectors may be getting de-rated on account of the higher interest rates and the moderation in activity which is sought to be achieved through the higher rates, this could be particularly noteworthy in the case of highly interest-sensitive sectors — such as banking, financial services and real estate. From a market point of view, the headline impact could be sharp given the prominence of such interest-sensitive stocks in the major indices.

Therefore, it may not be unwarranted to brace oneself for increased levels of volatility in global stock markets in the days ahead. Till the transition to a neutral level of rates, more instability would have to be reckoned with. Given the strengthening linkages between the Indian and global markets, one should expect the Indian markets also to reflect the increased levels of global volatility in the days ahead.

Impact on rupee

The rupee will be impacted by the volatility flowing in from the stock markets as the developments in the past week showed. While the rupee outlook for the medium-term is quite bullish on the back of the high growth prospects of the Indian economy, near-term volatility could be transmitted from other financial markets. That is, while the medium-term trend for the rupee is up, there could be short-run fluctuations, which could take the currency away from the medium-term uptrend line.

Key to the magnitude of such short-run fluctuations (on the downside) for the rupee could be the following the state of the interest rates cycle in India the appreciation by the market of the largely domestic demand driven nature of Indian growth and the stance of the Reserve Bank of India on foreign exchange market intervention global currency market developments any spike in oil prices which may be caused by the upcoming hurricane season in the Atlantic Ocean.

Rates have been rising in India for the past almost 3 years. The move up in rates so far has not had any noticeable adverse impact on the level of corporate performance — both of the listed and non-listed variety. At the same time, there has been a slight moderation in the growth of the main aggregate measures of economic activity — such as bank credit, money supply and wholesale level inflation — in recent weeks. If this trend of moderation were to be sustained, we could have transited to a level of rates, which is neither too restrictive nor too accommodative.

This could have some positive implications for the rupee despite any possible widening in differentials between Indian and foreign interest rates.

Such a transition to a neutral level of rates as indicated above could reinforce the benefits of the largely domestic demand driven nature of Indian growth. Corporate performance may continue to be good enough for attracting more investment capital in that scenario.

Other factors

The Reserve Bank of India's overbearing presence will always be a key factor determining the pace at which the rupee moves — either way — in the markets. If the latest dip in wholesale level inflation (sub 5 per cent reported for the week ended May 26) is sustained, we could possibly see a resumption of RBI dollar purchases (after factoring in the liquidity in the markets net or without the RBI's intervention) sometime in the 3rd or 4th quarters of the year.

Other key variables to be watched for gauging the rupee would be the performance of the dollar in the global currency markets and the impact which the upcoming hurricane season will have on global oil markets.

The dollar is displaying quite some resilience around the 1.34 levels against the euro / 1.98 levels against the pound and around 121.50 against the yen. Recent economic data from the US is providing good support for the US unit and there could possibly be a dollar turnaround if the pick-up in activity in the US noticed so far in the 2nd quarter solidifies into the latter part of the year. A strong dollar turnaround could be somewhat bearish for the rupee though it may not affect the underlying trend by much.

On the whole, investors in all markets may have to brace themselves for some increased volatility in the near term.

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