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'Gradual rate hike by Fed works best for US, global markets'

By Nizam Idris
March 19, 2015 10:56 IST
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Amid fears the US Federal Reserve might increase interest rates sooner than expected, the dollar has gained against most currencies. Singapore-based Nizam Idris, managing director & head of strategy (fixed income and currencies), Macquarie Bank, says the Fed does not want a normalisation that could lead to a messy global market reaction; that would harm the US markets and the overall sentiment.

A gradual increase works best for the US, as well as global markets, he tells Puneet Wadhwa.

“The market will likely continue to view India as a favourable investment destination, largely driven by the promise of reforms that might unlock India’s potential.” Excerpts:  

The fear of a sooner-than-expected increase in interest rates has spooked global markets; the euro has hit a 12-year low against the dollar.

The Brazilian real is at an 11-year low and the ringgit is at a six-year low. Could this be a beginning of a full-blown currency crisis? How prepared are global economies to handle this?

Despite the pace of the dollar’s appreciation, I am not of the view that this is the beginning of a currency crisis. I do not think this is 1994 again for the emerging markets (EMs).

To put things in perspective, the DXY dollar index is up 26 per cent from a year ago, and is back at the level last seen in 2003. But the index is still 21 per cent below where it was before the dot-com bubble.

Meanwhile, global balance sheets are actually not stretched enough for the dollar rally to lead to a crisis.  

EM foreign reserves are large, levels of external debts denominated in dollar are low, while current account deficits are generally smaller than what those were before 2008-09.

Finally, key economic indicators in the US are not accelerating as rapidly as the dollar rally seems to suggest, making it hard for the US Federal Reserve to justify increasing rates aggressively in the months ahead.  

A strong dollar is beginning to hurt US corporate earnings, 46 per cent of which come from foreign operations. All these add up to some support for the dollar but not a crisis.

Indeed, I do not think the dollar can sustain its current pace of appreciation.  

How soon do you expect the Fed to raise rates? Do you think this could trigger a risk-off trade in EMs? What could be the implications for India?  

Our base case is for Fed to increase rates in June.

This is earlier than expected and will, therefore, likely mean the dollar remaining firm in the run-up to the hike.

But we also have the view that the Fed will increase at a slower pace than feared. We are not ruling out a 12.5-basis-point (bp) at each US Federal Reserve meeting.

This will be the policy-rate equivalent of Fed’s move to exit from its monthly bond-purchase programme.

The move to taper its asset-purchase programme was so gentle that US Treasury yields plunged after a taper was announced in December 2013, despite a sharp rise before that.

We could see a gentle normalisation of interest rates from the Fed from June. This could see the dollar weakening after a big run up ahead of the hike.

The implication is, therefore, likely to be minimal. To my mind, Fed does not want a normalisation that might lead to a messy global market reaction.

That would harm the US markets and the overall sentiment. A gradual increase works best for the US and global markets.

This seems the most likely course of action in my opinion.  

What is your interpretation of key economic data coming from the euro zone, China and Japan? Within EMs, how does India now appear as an investment destination?  

As an investment destination, India is quite independent of what is going on in the euro zone, China and Japan.

The market will likely continue to view India as a favourable investment destination, largely driven by the promise of reforms that will unlock India’s potential, given the country’s positive demographics, growing middle class and a generally untapped market potential.

Indeed, to the extent that stronger global demand would work to its advantage, and some stability in the euro zone, China and Japan, could help India unlock these potential at a faster rate than in an environment of weak global demand.

Do you think EMs have now become more vulnerable to the risk of a sudden stop in capital flows? What about India?  

We are not of the view that EM economies are on the verge of a blow-up, regardless of the dollar’s strength and a potential hike in rates by the US Fed.

This is based on our view that, first, the US Fed will hike only gradually, plausibly at a pace of 12.5 bp per meeting; second, the dollar’s appreciation will begin to moderate, if not reverse slightly, in the second half of 2015, on the back of a slower interest rate normalisation; and third, EMs in Asia are better placed to navigate around a Fed rate hike, given higher foreign reserves and lower exposure to external debts.  

Do you think India is in a better position to manage any shock related to dollar and crude oil that might spring a surprise going ahead?  

Yes, I do believe so.  

Do you think that the Reserve Bank of India (RBI) could now be in a prolonged pause mode as regards cutting key rates, given how the global and domestic macros are shaping up?  

We are of the view that RBI will cut at least one more time, with a potential for another cut in the second half of the year if inflation continues to behave as we think it will, and if the US Fed’s rate normalisation is more benign than feared. 

What is your outlook on bond yields and the rupee (against the dollar)? Do you think the kind of inflows we might still see in both equity and debt markets will eventually lead rupee higher than where it is at present?  

We expect the rupee to stabilise in the near term against the buoyant dollar. But, given our view that the dollar could moderate in the second half of the year, we think the rupee’s value could be 62.0 to 61.50 a dollar by the end of the year. Separately, we think India’s 10-year yields will likely range between 8 per cent and 7.5 percent in the months ahead.  

A stable currency, easing inflation numbers and a central bank seemingly comfortable about easing its monetary policy (the two recent out-of-turn rate cuts being an example) suggest easier monetary policy could be sustained for a one, if not two, more rate cuts ahead. 

What is your strategy at Macquarie, given these developments and the economic scenario, especially in the Indian context?  

For now, we like going long on India’s bonds and the rupe. In the case of the rupee, though, we would not go long on the currency’s value versus the dollar.

We will, instead, trade the rupee in relative value terms.

At various stages in the past few months, we have gone long on the rupee versus dollar and the rupee versus the Singapore dollar, and more recently on the rupee versus the Chinese renminbi. These trades have done well in general.

We are mindful that the rupee has appreciated meaningfully against its trade-weighted basket in REER (real effective exchange rate) terms. But we remain of the view that at current levels the rupee REER remains modestly undervalued against its longer-term averages.

Image A pedestrian looks at an electronic board showing the stock market indices of various countries outside a brokerage in Tokyo.

Photograph: Yuya Shino/Reuters

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