Does this mean India, with world-leading growth prospects by even the most conservative of assessments, is immune to the unrelenting northward march in global risk-free rates that are at their highest since the Global Financial Crisis? Well, not quite. Rather, a relatively circumspect pace of ascent for the US Dollar Index explains the soft landing in Indian equities thus far.
Hence, the relative strength of the dollar, more than any other factor, should determine the near-term trend in Indian financial assets. To be sure, the euro, the yen and the pound sterling make up more than four-fifths of the US Dollar Index, which last recorded a reading below 100 as far back as July 19.
A reading for that barometer above 100 points to appreciation in the dollar against the basket of competing major currencies; a reading below 100 indicates dollar weakness.
The current dollar appreciation cycle is now on course to stretch way beyond a quarter, with a rate of climb exceeding 2 percentage points a month from the last sub-100 reading in July. It’s steep, of course, but pales in comparison with the 9-plus percentage point-equivalent monthly rise in US yields since September 1.
“Negative spillovers from US dollar appreciations fall disproportionately on emerging markets when compared with smaller advanced economies,” the International Monetary Fund said in a study on external sector implications of the global dollar cycle. “Impacts on emerging markets are large in economic terms: a 10% US dollar appreciation decreases output by 1.9% after one year, and the negative effect dissipates only after 10 quarters.”
Impact on India
In relative terms, India is less susceptible to the dollar march since it is more of an importer of commodities than an exporter of unprocessed resources, which are globally priced in dollars. Still, an unrelenting northward dollar cycle will likely exert a greater influence on India’s rate-setting panel than the absolute value of US yields, with the central bank having to defend the rupee to prevent imported inflation.
The cascading impact of such rate increases on the economy – and local equity gauges – is negative.
Correlation studies dating back decades show that weaker dollar cycles have almost always coincided with outperformance by emerging markets. The reverse, unfortunately, is true when the dollar strengthens. Indeed, since the Nifty first hit the 20,000 mark on September 11, the dollar index has climbed 1.7%; the stock gauge has lost nearly 4.5% in this period.
The central bank is unlikely to feel compelled to raise rates in response to hardening US yields as long as real rates in India are positive, with a percentage-point positive margin at least, despite the narrowing differential with US risk-free rates.
So, after the two-day rout in this truncated trading week, the question to ask is: How long will the dollar appreciation cycle last? A retreat, although very much welcome, is unlikely soon.
“As per our assessment, the dollar index moves in tandem with the commodity index, including Brent crude price, but with a lag,” JM Financial said in an assessment of the macroeconomy. “We expect Brent crude to remain elevated in the near term, which would keep the US dollar at these levels.”
If that scenario were to play out, D-Street bulls might be missing in action in the coming weeks.