As we head into the final stretch of 2021 we see the USD at near the top end of a very flattish year- the range so far restricted between 72.30 and 75.50. Much of the year has been anticipatory in nature: waiting for the pandemic to leave; chased away by the miracle vaccine. In the meanwhile, a combination of easy liquidity and low rates have been the norm- keeping markets buoyant and yields low. Things are about to change.
The big questions for markets centre on rates and liquidity; more so than growth which now works more in micro decisions. The biggest influencer is the United States and the biggest players in the United States are the Federal Reserve and the US Treasury. So, their decisions this month are critical.
Former Federal Reserve Chairwoman and current Treasury Secretary Janet Yellen is trying to convince the world that the US has inflation under control and that the current spike to 5.4% is transitional and due to supply chain disruptions. That is only partly true. The US is also facing labour shortages arising out of an unwillingness to go back to work at low wages. Supply chain disruptions are being felt globally but the US is- again, particularly badly hit. The rest of the world are more concerned about rising energy prices.
With gas, heating oil and oil prices up dramatically over the course of this last year the other main pressure point for inflation is going to be felt going into the northern hemisphere winter when demand surges. So, we can see that there will remain some inflationary pressure which is then going to push up pressure on central banks to reduce liquidity and raise rates. We’re already starting to see that in India with the average daily liquidity surplus with banks which had touched 11 lakh crore rupees (11 trillion rupees or USD 146.7 billion- just over 5% of the GDP) slowly reduce. The plan is to bring it down by over 5 lakh crores by December). The US is expected to announce its tapering programme as early as the FOMC on the 3rd with inflation running hotter than expected and the Fed committed to keeping rates as low as possible until unemployment levels come lower. That may be the wrong tool for the wrong job but the trouble is that financial markets are used to being coddled by the Fed and want ultra-low rates to justify high equity prices.
A lot hinges on the inflation scenario. Rates are the first domino. If rates rise then equity will come lower. If money is taken off the table from Emerging Market equities (as they would be if US rates climb), then EM currencies will start to face weakening pressure and the USD will strengthen. The question isn’t if rates start to rise now- it’s almost certain that it won’t happen until sometime next year- in the US if not elsewhere; the question is how will central banks start to communicate their intentions without setting off panic? A few of them will be making their decisions about rate hikes this week itself. The Bank of England may announce the raising of interest rates to head off possible inflationary pressure. This will be a tough decision as the equity markets are gathering up a head of steam to make another bull run. Tesla, on the back of a 100,000 car order from Hertz rentals is now a trillion dollar company- with annual revenues of under USD 50 billion.
Locally, October saw Indian manufacturing PMI rise to 55.9- much higher than expected and much higher than September’s 53.7; but rural unemployment is also on the rise- though partially offset by urban employment. Still, the overall unemployment trend is up as are prices of fuel and cooking gas- which will cause some distress amongst poorer households. Interest rates are at a historic low but there isn’t sufficient leeway on the inflation front which- averaging at above 5.2% for the year to date, does not leave much headroom from the RBI target at 5.7%. That is to say, the RBI cannot afford to keep a record low rate as inflationary pressures build up without falling behind the curve.
Rising oil prices pose a problem to the inflation scenario and this doesn’t look like easing. Already at 3 year highs the speed of the rally threatens to choke off the possibility of growth if it leaks into inflation and then interest rates. This is a problem that the world could do not having to contend with.
In all of this the INR has been pretty docile, rallying from 74.05 to touch 75.50 briefly last month and then settling into a range oscillating around 74.80-75.20. There is the expectation of large inflows early on this month and we could see a shallow dip in the dollar. But overall, there is a minor bullish tone to the greenback and we could see a 74.00-76.00 range this month. This is not the prelude to a dollar take-off and we may see the dollar again settle down thereafter. The reason for this is that the spikes seem to have a limited capacity for upside pressure as well as a limited time duration of effect. Furthermore, the IMF has indicated to India that it needs to slow down its reserve accumulation- a subtle way to hint that India is indulging in price manipulation. With the Chinese Yuan still fairly strong there is less pressure to weaken the INR just at the moment even though the Dollar index has been gaining strength.