Forex Management: A change of guard!

It is an open secret that rupee is a managed currency i.e. RBI occasionally (rather regularly) intervene in forex markets arguably to reduce volatility in the currency. Over the last few months, RBI has been intervening aggressively to keep rupee appreciation in check. To put things into perspective in the current financial year (1 April onward till 21 Aug) US dollar index tumbled more than 7% from 99 to 92 handle. During the same period, USDINR pair fell just 0.5% from 75.33 to 74.92 levels. There have multiple theories to explain RBI intervention behaviour, one such theory works on RBI’s dividend to the government. The theory argues that high USDINR levels increase the valuation of RBI’s FX reserves, thus impacting the final dividend to the government!

Yield play

Another key function of RBI is to manage the government’s borrowing programme. Apart from aggressive interest rate cuts, RBI has also been very innovative to increase liquidity in the system and managing longer-term yields. Prior to inflation data (Aug 14), 10-year g-sec bond yield had been in the range of 5.75-5.95%. 10-year bond yield break-out of this range after the release of July headline inflation surged to 6.93% out of RBI’s target range of 2%-6%. Dr Michael Debabrata Patra’s comments in meeting minutes “inflation surprises of recent months are undermining the MPC’s actions and stymieing its resolve to do what it takes to revive growth and mitigate the impact of COVID-19 on the economy”. Post the release of meeting minutes yield surged to 6.22%.

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Measures to Foster Orderly Market Conditions

Yesterday, RBI announced slew of measure to manage for bond yields: Operation twist of INR 20k Cr, Term repo of INR 100k cr, increasing limits of HTM category to 22% of NDTL. All these measure are likely increase market appetite towards government bond borrowing programme. Consequently, 10 year bond yield opened with huge gap down at 5.95%.  10 year bond yield has multiple supports at 5.93-95%, a break below might pave the way for 5.80%.

What caught the eye of currency traders is “the recent appreciation of the rupee is working towards containing imported inflationary pressures”. This primarily means that RBI might not be aggressive/assured buyer in USDINR markets. This lead to free fall in USDINR, which tumbled to 72.80 against yesterday’s high of 73.70 levels. Technically, USDINR pair has minor support near 72.50-60 levels and strong support near 72.00 levels. The relationship between rupee and headline inflation via imported inflation is such that for every 5% gain in rupee lead to 20 bps decline in headline inflation. In current times, this impact would have worsened more given lower imports and lack of consumption. So, we can argue on the efficacy of stronger rupee in pursuant of softer inflation but for rupee bulls – such hint from Mint Street is enough to ignite a rally in the currency.

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