Kotecha highlighted that the rupee is overvalued based on nominal and effective exchange rates. Factors such as a potential depreciation of the Chinese yuan, India’s trade deficit with China, slowing growth, export-driven policies, and a stronger dollar could exert further downward pressure.
The rupee, which has faced global and domestic headwinds, slipped to an all-time low of 85 against the US dollar on December 19, following a hawkish shift in tone from the US Federal Reserve Chair.
Neeraj Gambhir, Group Executive and Head of Treasury at Axis Bank, believes the RBI may face less pressure to cut rates in February, partly due to the US Fed’s pause in aggressive rate cuts.
However, circumstances could still change before the next policy decision.
These are edited excerpts of the interview.
Q: It’s 108 on the dollar index. Have we seen the worst or can we see the dollar rising even more?
Kotecha: The answer is we can see the dollar rising more. Our view is that there is going into next year more upside risks. We have had this kneejerk reaction of the dollar to the Fed. But that said, next year, in January, we have a very big event, the inauguration of President-elect Donald Trump, and potentially very significant tariffs placed on China and the rest of the world.
Also Read | Trump and China may be two big reasons why the US Fed turned hawkish: Explained
The US economy continues to outperform from a growth perspective, but China’s economy is still fairly weak. The rest of the world is still flagging in terms of its growth. So all of that seems to show that the US is attracting capital from elsewhere, and that means the dollar upside continues to see momentum here. So while it is not going to be a straight-line dollar appreciation, and again, a lot will depend on Trump’s policies, we do think the direction of travel is still for a higher US dollar into the first half of next year.
Q: What about yields? This 4.5% was not expected. Many people expected that the Fed would tone down rate cuts next year. four getting reduced to two cuts by the FOMC, dot plot was perhaps not in the price, but 4.5% for the 10-year. Where do we go from here?
Kotecha: It does feel like the market has gone too far in terms of yields. And, if you look at what has been priced in for a terminal rate, now it looks a little high. It seems, in our view, that even 10-year yields have probably backed up a lot in the current range. We were looking at 4.25-4.5% range.
The Fed has moved into line with our view for next year, that we expect two cuts next year, and the dot plots now are showing that, but I think there is still room, ultimately, for the interest rates in the US to continue to decline gradually.
The labour market is starting to loosen up a little bit now, inflation, although it has been a bit sticky, is moving lower in the US and to the Fed’s target. So, there shouldn’t be much in the way of further reduction in rates.
So, this move in interest rates appears to be a little bit more aggressive, and it is a knee-jerk reaction. Our interest rate strategies have taken the opposite view they have taken. They have gone long one-year, and two-year US rates, and are of the view that the market is a little bit too hawkish in terms of what they are pricing.
Q: Let us assume, for argument’s sake, that the 4.5% continues when the RBI meets in February. They already have had the January 20 inauguration. So, does this change the position in terms of the expected rate cut?
Gambhir: If you look at the February policy, I think there are three things that the RBI would want to focus on. One is growth. We have had much slower growth as compared to expectations. The second is currency. Currency is weak, although the rupee continues to be one of the strongest currencies on relative terms as compared to even currencies like the Singapore dollar and the Indonesian Rupiah. So while the currency is weak, there is pressure on the currency, but the Reserve Bank continues to manage the volatility in the market.
Also Read | What drove the rupee to its all-time low of 85 against dollar
Third is the overall inflation outlook. You had stronger-than-expected inflation in some sense. Food and vegetable price inflation continues to exert upward pressure, and between now and February, we will need to see how each of these three variables plays out.
We should see some normalisation of growth as government spending has kicked in and as the RBI has induced more liquidity into the system.
On the inflation front, the key driver will be what happens to the food and vegetable prices. So far in December, there hasn’t been much respite. So if the inflation print continues to be higher than what the market expects then that is something which speaks against a potential rate cut in February.
As the dollar strength continues, the currency pressure will be there. So all in all, it is still a possibility that RBI might cut the rate. So February is live in that sense. But the pressure on RBI to cut rates in February, in some sense has lessened to some extent, as the Fed has also backed off from its aggressive rate-cutting cycle in the next year. A lot can change between now and February, but there is less pressure on RBI to think of a rate cut at this point.
Q: It has taken a while for the rupee to cross 85 per dollar because of stiff resistance from the RBI. Where do you see it by year-end but more importantly, by March end?
Kotecha: We continue to see a depreciation of the rupee. Our view has been that there has been aggressive intervention in recent months, and that is probably artificially stopped the currency from weakening to a more natural level. I agree that the rupee will outperform its peers in Asia, but that doesn’t mean that we won’t continue to depreciate. So, for example, we are forecasting 87 per dollar by the end of next year, which given the pace of the move in the dollar that forecast is on track as we currently speak.
And ultimately there is a few factors here. We believe the rupee is rich on a valuation basis, both on a nominal and an effective exchange rate basis. We think we are focusing, again, on the yuan as a key factor here. If the yuan depreciates more significantly, which we think it may do, that could also exert downward pressure on the Indian rupee, and that trade deficit with China, of course, is quite important.
So you have got that, the slowing in growth, the push for exports and manufacturing, and broadly a stronger dollar. So, all of those factors play for dollar/rupee higher. The question is, what pace? But we think the RBI will continue to control the pace of depreciation, but not stop it or reverse that depreciation trend.
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