What is your interpretation of the economic data on the US, Europe and Japan and how do you expect the central banks in these countries to react to this through the next 6-12 months?
At Macquarie, we believe the current trend of a gradual improvement in US data is not matched by data outturns out of Europe and Japan. This presents a case for diverging monetary policy biases among the G3 central banks, through the next 6-12 months, favouring strengthening of the dollar over the euro and the yen. The dollar could draw support from improving fiscal and current account balances, along with healing in the domestic housing market and manufacturing sector. We expect the US Federal Reserve to raise rates in March 2015, well ahead of the market’s current consensus forecast of June 2015. Should US data continue to strengthen, the market will gravitate to our forecast, providing more support for the dollar.
The dollar has been strengthening against most global currencies. Do you think this could trigger risk-off trade, as far as the emerging markets are concerned? What are the implications for India?
The dollar’s current strength is based on the right reasons — growth indicators are improving, while inflation expectation is gradually returning to the targeted range. This is different from the decision to end QE3 (third round of quantitative easing) last year, when growth data were still unclear and the US Fed was hinting at the lack of effectiveness of the QE in boosting growth and supporting inflation expectations. This is, therefore, not a repeat of May-August 2013, in our view.
Carry trade and emerging market currencies were hurt when the US yield curve bear steepened (higher long-end yields). This will not be the case when the US curve flattens due to higher short-date yields. The latter scenario is positive for the dollar, instead of specifically hurting emerging market currencies. We expect the dollar to strengthen across the board. Emerging market currencies will weaken but won’t be routed. This is not a repeat of the taper tantrums of 2013.
Still, expect the USD to be strong until the first rate hike is announced, after which, we expect the US Fed to signal at a very gradual hike cycle, taking the wind off the dollar's sail thereafter. This would be similar to how the 10-year UST yield reacted to the taper announcement - rising sharply initially but immediately losing steam once taper was finalised in December 2014, after which yields have eased back to around 2.5% currently.
Last week, the dollar hit a new six-year high against the yen. Do you expect a more aggressive stance by the Bank of Japan (BoJ), in terms of quantitative easing measures?The short answer is no. The yen’s weakness is a relief for the BoJ, giving it time to contemplate what to do next. A depreciating currency has helped Japan’s growth, through exports and inflation and through higher import costs in local currency terms — both are the stated objectives of the BoJ. This means the BoJ will likely continue with its current quantitative easing plan for now.
The government may, however, have to review the plan to hike the sales tax by a further two -percentage points next October should domestic demand remains weak. Japan may need to reform its labour laws to encourage wage hikes to counter the negative wealth effect from higher sales tax. But such changes may not be popular as it would also mean making it easier for firms to fire workers. This remains a big factor that remains unfulfilled as part of Abenomics' third arrow. This decision though may only be finalised in the middle of 2015.
Where do you see the dollar through the next three months?Based on our view that first, there will be broad dollar strength, as an earlier rate rise is priced in, followed by moderation in dollar upside once it is clarified the US Fed will move early, but gradually, in normalising interest rates, we have a forecast for the euro-dollar equation to fall to 1.24, the dollar-yen to rise to 114 and the dollar-rupee to rise to 62.5 in the next three months. There is, however, scope for the dollar to give up some of these gains, with the dollar-rupee likely to ease back to 61 by mid-2015.
Do you think India is in a better position to manage any shock related to the dollar or crude oil?
The RBI has tightened the monetary policy, raised India’s real rates, curbed speculative imports, raised its forex reserves and anchored inflation expectations through the past year since (RBI governor) Raguram Rajan took charge. The market assigned a decent amount of credibility to RBI’s inflation targets for 2014 and 2015. Also, the government has restricted the import of gold and luxury goods, narrowed the fiscal deficit and lowered the overall current account deficit. Exogenously, commodity prices have also fallen. In aggregate, these certainly put India on a better position to endure any fresh bouts of dollar strength. This is reflected in our forecast of only a modest upside in the dollar-rupee equation through the next three-six months.
Do you think the Indian economy is out of the woods and firmly on a revival path?
India’s economy is now on a stronger footing. Policy actions by RBI in tightening the monetary policy has stabilised the rupee and anchored inflation expectations. Fiscal policy discipline, seemingly hard to achieve without compromising growth, has also assured investors the fundamentals are stabilising, allowing easier investment decision-making.
How do you evaluate the first few months of the current government, in terms of the policies it has announced? Do you think it has been a case of ‘high on hope and low on delivery’? What other policies and initiatives do you want to see through the next 6-12 months?
The National Democratic Alliance government, under (Prime Minister) Narendra Modi has maintained a positive tone in its policy rhetoric, alluding to reforming the economy through infrastructure investment and opening the market to global investment. These are not policies that can be implemented in the short term, or on a knee-jerk basis. While the delivery has been perceived as minimal so far, expectations have remained high. I will only begin to worry if no further signs of reform are announced by the next Budget.
Given the economic scenario, what is your strategy at Macquarie? Within emerging markets, how does India appear as an investment destination?
We do not expect a straight-line move in either direction. We are still positive on the rupee. While we think it will not be able to resist the broadly-strong dollar in the next three-six months, till the US Fed clarifies the trajectory of its rate rise cycle, we expect an earlier, but more gradual, rise than the market current expects. However, we think the domestic story could take over after that and pull the dollar-rupee lower, subject to deepening of the government’s reform moves.