Are equity markets pricing in rupee weakness and related risks?

Analysts say equity markets will begin baking in the negatives and weakness in the rupee if the US Fed chief Jerome Powell delivers a hawkish commentary at Jackson Hole later this week

The growing risk-off sentiment across global financial markets is likely to keep the rupee under pressure in the near term, analysts said, as the strength in the US dollar is unlikely to ease anytime soon. 

Meanwhile, equity markets, they believe, have not fully factored in the weakness in the Indian currency and its related risks yet. 

“From a near-term perspective, we maintain a depreciating bias on the rupee due to rising crude oil prices and volatile inflation trajectory but this has not been fully priced in by Indian markets," said Prashant Pimple, CIO-fixed income at Baroda BNP Paribas Mutual Fund. 

Bets that more rate hikes are in the offing in the US have sent their 10-year bond yield to 17-year high of 4.35 per cent, while the US dollar is hovering around a 2-month high of 103. 71.

Notably, the yield spread between India's 10-year G-Sec and US 10-year bond is at a multi-year low of 292 basis points as against 400 bps at the end of August 2022. 

V K Vijayakumar, chief investment strategist at Geojit Financial Services, believes markets will begin baking in the negatives if the US Fed chief Jerome Powell delivers a hawkish commentary at Jackson Hole later this week. 

“Since the dollar index and the US bond yields remain high, FIIs will not be strong buyers in the market. As current valuations are also high, any further negative trigger could see markets correcting ahead,” he said. 

A lower spread, which makes US bonds more attractive, with a weak rupee prompt foreign investor-selling from emerging markets like India in exchange for dollar-denominated investments. 

FII selling

Some early trends also suggest moderation in foreign capital inflows. Foreign portfolio investors (FPIs) have sold shares worth Rs 13,322 crore so far in August after their inflows hit a 5-month high of Rs 10,273 crore in July. 

Meanwhile, the FII selling can intensify as the rupee could tumble to as low as 84 against the dollar, as per analysts. 

Bank of Baroda economist Aditi Gupta, in a note on August 18, said a range of 83-84/$ looks reasonable for the next fortnight, with more upside possible amid weakness in the closely related Chinese yuan and boiling crude prices. 

“With the current global backdrop, more pressure on the rupee looks inevitable. While RBI is believed to be actively intervening in the forex market, there is still a belief that it may be more accepting of a weaker rupee since our export growth is facing headwinds,” she wrote. 

Banking system liquidity

Banking system's liquidity deficit following the implementation of incremental CRR requirements could also limit RBI’s ability to intervene in the currency market, which may keep the rupee under pressure, Gupta believes. 

The rupee slipped to a record closing low of 83.15/$ last week, a few paise away from its lifetime low of 83.29/$ touched on October 20, 2022. At the beginning of 2022, it was around 74/$.  

Although, the local currency has been resilient this year being broadly flat so far in 2023 as compared to the 10 per cent depreciation last year. 

“Notwithstanding the short-term weakness, we are slightly bullish on the rupee in the medium term on the back of the firm domestic economy,” said Prashant Pimple of Baroda BNP Paribas Mutual Fund. 

The currency, experts say, will likely pull back from its current low levels in the medium term as the recent weakness can be largely attributed to external factors as domestic macros continue to be favourable.