The global economy seems to have reached an inflection point with sentiment on inflation making a definite reversal. This is most prominently reflected in the increase in oil prices from January's low of about $50 for the benchmark Brent crude to almost $70 currently. The month-long rally in oil has been driven by a sense that the global economy has bottomed out and a recovery is more than likely in the second half of 2015. The outlook on physical supply of oil is still uncertain: while the rally has been strengthened by reports of a sharp drop in US stockpiles, some reports suggest that supply of oil still exceeds demand by 1.5 million barrels per day and a correction in oil prices is imminent. Be that as it may, the change in sentiment regarding global demand is the primary influence that is driving reflationary trades across most commodities including metals.
The same sentiment is reflected in a sell-off in the global bond markets, which had so far been driven by deflation concerns. What was the trigger for this change in global sentiment just when we were getting used to the "new mediocre" of low growth and low interest rates? We believe it was the signs of a recovery in the European economy, boosted by central bank stimulus and weakness in the euro. The International Monetary Fund's recently published World Economic Outlook has upgraded its forecast for euro area growth for 2015 and 2016 by 0.3 and 0.2 percentage points, respectively. Thus, the region is now expected to grow at 1.5 and 1.6 per cent in 2015 and 2016, up from 0.9 per cent in 2014 and a decline of 0.5 per cent in 2013. A splendid recovery, if indeed these numbers turn out to be correct.
The improved outlook for the global economy has in turn had an impact on the optimism towards the dollar, which had been rallying since the beginning of 2014 but has recently begun to weaken. With the US economy no longer expected to be the sole region in the developed world experiencing a recovery, the trade-weighted dollar index recently peaked. Of course, the weakening of the dollar could be stalled if the US Federal Reserve decides to raise policy rates, but we suspect that movements in the exchange rate will be driven more by relative strength in growth rather than policy-driven rate differentials. Over the coming months, it may be prudent to expect the euro to recoup some of its lost ground to the dollar, given the relative outperformance of the European economy.
The softer dollar will, of course, reinforce the rise in commodity prices, which are dollar-denominated. The consequences for net importers such as India are clearly negative. Just as the dip in oil prices had buoyed sentiment on India for the past year, a reversal will have an equally strong impact, which is already evident in the recent sell-off in Indian equities. What's more, hopes of a rate cut by the Reserve Bank of India would begin to fade if commodity price increases begin to show up in inflation rates creeping up. Of course, it is not all gloom and doom. A recovery in Europe should help exporters who have been affected by the long slump in their key market.
Another possible fallout of this play of forces is a sharper up-move in the euro that has already gained considerable ground against the dollar. While it seems certain that the European Central Bank is unlikely to raise rates in the forseeable future, the attraction of borrowing cheap in euros should be tempered by the risk of its appreciation against currencies such as the rupee. Thus, euro borrowers should hedge in a hurry.
Also, if the rupee remains under pressure and bond yields spike up, as they have in the last few days, the government might not have an option but to hike foreign investor limits in local debt just to stem the fall.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is principal economist, CII
These views are personal
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