Come 2019! Reverse in dollar rally seen soon; here's where Indian rupee will stand

India is on nervous breakdown, since the time its domestic currency started touching an all-time low against US benchmark dollar index at interbank forex market. Because of depreciating rupee, investors have lost faith in markets, the country's current account deficit (CAD) has widened to five-year low, and government is forced to increase import duty of 19 products at latest. RBI's intervention is need at urgent level, however, when the rupee is volatile against the dollar in market, there is hardly any regulatory can do much in controlling the currency.

Today was no different, Indian rupee was trading above by 0.01% against the American unit at 73.375.

Since start of 2018, Indian currency has touched an all-time low of 73.725. However, it is dollar's overvaluation that is to blame on the free fall in Indian currency. It's not just Indian rupee, even other currencies on emerging market has taken hit massively against dollar. This calls for understanding to how far dollar is expected to rally, and what happens to Indian rupee in near term.

Anurag Shastri, Senior Associate at HDFC Bank said, "Some EM currencies have fallen sharply in recent months and as a pack are undervalued. This warrants some appreciation against the dollar. However, given the continued rotation of funds away from the EMs, the extent of the recovery in EM currencies remains unclear."

To put this in perspective, the movement in the dollar index could be an important determinant of the trajectory of EM currencies, like the INR, over the next 6-8 months. So where is the dollar headed?

Shastri said, "The dollar as measured by the DXY has rallied by over 6% since February, driven by strong US growth (at 4% In the second quarter), the safe haven trade and high interest rate differentials. This has led to the view that the dollar is overvalued and a correction is in the offing."

"We think that while in the near term dollar strength is unlikely to abate significantly, we could see the dollar rally reverse as we get closer to 2019," said Shastri.  

According to the HDFC Bank reports here are the six reasons that could lead to a change in the direction of dollars.

1. Overvaluation’ signals impending correction: Firstly, the dollar is clearly overvalued and more appreciation could start impinging on US growth adversely affecting exports. More importantly it could encourage imports, working directly against the ‘’Make in the US ‘agenda. Conventional measures such as the REER suggest an overvaluation of close to 10% according to IMF data and close to 15%
as per the BIS REER measure, as of July 2018. Also, a simple technical analysis of Bollinger bands (calculated by using standard deviations) shows that the dollar is clearly close to the upper bound of the bands - which signals overvaluation.

2. US growth to slow down: First, there are tentative signs of wage pressures slowly building up that could keep the Fed on the rate hike track. Second despite somewhat overt pressures from the White House, the Fed does not seem keen on adventurism and is unlikely to support expansionary fiscal policy by loosening its monetary grip. Finally, a full blown trade war could push costs up and lead to supply disruptions, causing both cost-push inflation and whittling down firm competitiveness. Thus it is very likely the US growth is likely to slow down in 2019 as the impact of trade war filters in and monetary policy continues to tighten.

3. Interest rate differential narrows: As the ECB comes to the end of its ultra-loose monetary policy and the Fed moves closer to its neutral rate, global interest rates will start to converge and the dollar could start to decline.

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4. Talking down the dollar: As we have mentioned earlier, a strong dollar works against President Trump’s agenda of nurturing domestic industry. Trump has made it clear through his recent comments that he does not support a strong U.S.dollar and once headline growth or export data start to disappoint, his efforts to talk the USD down could amplify.

5.Worries over the twin deficits return: Historically the US fiscal deficit and the dollar index have had an inverse relationship with periods of high fiscal deficit coinciding with a lower dollar index. Drawing from this relationship, we can expect the dollar to feel some pressure as the fiscal deficit continues to rise this year and the next.Given the tax cuts and increased government spending, US fiscal deficit as a percent of GDP is expected to rise to 3.9% in 2018 and 4.6% in 2019 as per the Congressional Budget Office’s latest projections.

6.The Oil effect – lower consumption versus higher production: The net impact depends on the level of oil price where in, one of the effects outweighs the other.

So far, higher oil prices have had a net positive impact on US growth – oil and gas related investments accounted for 40% of the growth in business investment in the April-June quarter this year.

That said, a sharp increase in oil prices – with impending US sanctions on Iran – could tip the scales unfavorable for overall US growth.

Considering the above, Shastri said, "it is assumed that although the rupee could see some respite and reverse from current levels, the recovery could be capped and USD/INR pair could settle in the range of 69-70 against the USD over a one-year period."