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Clearly, God reads my columns. After four weeks of on-my-knees pleas, the volatility in currency markets has finally come to life, courtesy the chuppa rustam dollar, which, at long last, appears to be stepping out.
As far back as July 2012, I have been looking for a turning point in the dollar. It had been falling, more or less steadily since 2002, from a dollar index (DXY) of 120 to as low as 73 in 2008. When the Lehman crisis hit, the DXY shot higher, reaching nearly 90 (representing the 38.2 per cent Fibonacci retracement) in a matter of six months. But the rally couldn't sustain and the DXY began to subside again; it made another attempt in 2010, but, again, it couldn't quite make the grade (of even 90) and gave up the ghost sinking back to 73 in 2011.
That's 10 years of decline.
In 2012, the dollar appeared to start up again, and since then the DXY has been jockeying about between 79 and 83. And now suddenly, in the last 10 days, the dollar seems to have broken through, with the DXY touching nearly 85, a four-year high. Could this be the turning point?
In support, there is already a significant mismatch in monetary policy - the United States Federal Reserve is certainly done with easing, whereas the European Central Bank is inching its way on to the QE (quantitative easing) maidan. There is the Scotland referendum, which, while currently simply keeping sterling off balance, reflects a deep dissatisfaction in several European (and other) countries, which points to increased uncertainty over the medium term.
And then, there's the yen. Always an odd bird, when the yen begins to move, it really moves. The last major yen move showed a peak-to-trough range of nearly 40 per cent; the corresponding number for the euro was less than 25 per cent. Thus, a disproportionate move in the yen often portends much more to come. In this current round, the yen has already fallen about twice as much as the other currencies (five per cent).
Reflecting all this nervousness (or excitement, depending on how you look at it), the DXY volatility has quickly shot higher - from three per cent to four per cent in a week. But it still remains way below the average level over the past five years, which was over eight per cent. This, too, suggests there could be more to come. If the DXY does indeed continue higher, the next stop would be 89-90 (the 38 per cent retracement). And if that blows through, we could be looking at 95-96 (the 50 per cent Fibonacci retracement level), or, even more frightening, the 61.8 per cent retracement, which would take the DXY into triple digits.
Of course, such a dramatic move could take several years - remember, the down move lasted around 10 years - and would certainly be interspersed with corrections, some of which could be pretty steep. But with the United States economic recovery at least visible, interest rates much more likely to rise than stay put, and alternative currencies looking dicey (as well, I note that Goldman has a 1,100 target for gold), the dollar could really be in for a good run.
All of this would have significant implications for the rupee. The REER (real effective exchange rate) model that we follow shows the rupee is already overvalued. Just as happened in 2013, foreign institutional investment (FII) inflows have been pushing the rupee higher than its "natural" level. At that time, the rupee climbed above the level forecast by the model in January and the overvaluation rose quickly to about three rupees. It remained overvalued at more or less this level till May, when Federal Reserve Chairman Ben Bernanke's signal that QE was about to end sent global markets into turmoil. The overvaluation made the rupee an easy hit, and as the selling accelerated, it collapsed falling to 68, 10 rupees below fair value.
Today, again under the influence of FII flows, the rupee has quite quickly (since late August) become (again) about three rupees stronger than forecast. Even the near one-rupee move in the past couple of days has not made a material difference since the DXY has continued to climb.
With India's macro and sentiment factors much more positive today than in 2013, the threat of a huge over-correction when the rupee normalises is reduced. However, if the DXY does hit even its first target (89-90), the model forecasts 67.50 to the dollar. And this is if it happens tomorrow; if it takes a few months to get to that level, the fair value would be even higher to account for the inflation differential.
Of course, fair value is just a number. The rupee can remain overvalued for a long time - theoretically indefinitely. However, the longer the overvaluation persists, the harder and deeper will be the fall, when it comes. Best if the rupee keeps edging lower to limit this threat. Rising volatility ahead - thank you, God.
jamal@mecklai.com
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
