Any experienced trader knows trends rarely end at ‘fair-value’ (FV). The prices of stocks, bonds, currencies and other financial instruments do have a ‘central’ tendency. When a trend has moved some distance from fair-value, it will reverse. But the trend reversal will also overshoot fair-value in the other direction. Hence, a trader shouldn’t hold fair-value in mind as a target when following a trend.
One problem is that FV is notional, since FV calculations start with a risk-free return and that varies from investor to investor. For a rupee investor, risk-free may be the return from a fixed deposit, or rupee treasury yield. That’s about 8 – 8.5 per cent now.
For a dollar investor, the risk- free USD treasury yield is between 1.6-1.9 per cent. In the euro, there’s a wide range between German treasury yield (0.02 per cent) and Spanish treasury yield (6.7 per cent), with other European Union sovereign yields clustered in between.
When calculating fair-value across multi-currencies, there is the added complexity of exchange rates. Currency exchange rates have fair values in theory but there are multiple models for calculations. The fair-value of a currency, with respect to another currency, depends on relative real interest rates, trade balances, relative inflation expectations, etc. In practice, currency rates fluctuate around fair-value just like other financial instruments.
This is why the perception that the rupee is undervalued is almost irrelevant. It is not quite irrelevant, since the rupee is not an entirely free currency. However, the Reserve Bank of India doesn’t have the ammunition in terms of reserves to impose a trend if it allows the rupee float to continue. And drastic steps like rigid currency controls could cause panic.
In technical terms, the USDINR made a breakout to a new low last week. The steps taken on Monday to induce a pullback were apparently, unsuccessful in triggering a reversal. The breakout remains valid.
Even allowing for short-covering and profit-booking at settlement from long USD players, it may be worth holding a long USDINR position unless the rate rises above 55.750 or so. The EuroINR has also made a breakout. In technical terms, it seems worth holding a long position with a stop-losst around 69.200.
A trader must watch out for potential trend reversals. As and when these occur, they will take the rupee back to over-valued levels. I’d say the rupee is over-valued if the dollar rises above 53-54, and the euro rises above 68-69. It won’t be surprising if the USDINR swings to 51.5 sometime within 2012, or if the euro suddenly falls to 65.
The author is a technical and equity analyst
