Ways to gain from continuing currency volatility

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The dollar-rupee rates changed dramatically after the Budget. In the past week, the rupee has shot up by over two per cent versus the dollar and it has gained by over three per cent against the euro and the yen in the same period.

The European Central Bank (ECB), the US Federal Reserve and the Reserve Bank of India (RBI) are all due for policy meetings in the next few weeks. The ECB meets this week while the Fed meets next week. RBI meets in early April. The RBI policy will surely be influenced by the Fed and ECB.

The ECB is likely to be accommodative, going by recent pronouncements and data, which indicates deflation. The European Union is also suffering political turmoil brewing, what with fears of "Brexit" and the refugee crisis. The political uncertainty means that the euro will tend to weaken even if the ECB does not take accommodative action. A Brexit could also do strange things to pound-rupee rates.

The Fed is unlikely to take concrete action. But, the dollar might gain if the Fed is perceived to be ready to raise US policy rates in 2016, so what the Fed says will move markets. A hike in 2016 is a possibility since the January non-farm employment data was much stronger than expected. In Asia, Japan is holding rates while China has eased reserve requirements for the fifth time.

The dollar is the world's reserve currency. But, RBI must obviously consider what happens to the rupee versus all currencies rather than just the dollar. The Real Effective Exchange Rate (REER) as calculated by RBI tracks 36 currencies, weighted by India's trade, and indexed to the consumer price index. The REER indicates that the rupee is over-valued. That gels with the fact that exports have fallen every month for 14 months in a row. If there is another round of competitive currency weakening with other major currencies dropping versus the dollar, the rupee will also need to lose ground to stay in step.

On the inflation front, RBI is targeting five per cent retail inflation by January 2017 (in terms of the Consumer Price Index year-on-year change over January 2016). The Budget is not very inflationary. But, inflation was higher than comfortable in January 2016 at 5.69 per cent.

One driver of higher inflation was food, which rarely gets cheaper pre-monsoon. The Centre has decided to maintain high excise rates at petrol pumps and mop up revenue on fuels rather than pass on lower crude prices. That removes another possible route to lower inflation. In any event, crude has seen a very substantial bounce in the past 10 sessions. RBI would like inflation to fall more. That implies it will not want to cut rates. But, what it does will be predicated on ECB and Fed action and attitude.

What we can predict is continuing currency volatility. The rupee could move violently in either direction and it might swing more versus the euro or yen than versus the dollar. It might also see divergent trends versus different currencies. At some stage, Brexit will make for big swings in the pound.

Trading currency futures involves very high leverage. It may be less risky to trade information technology (IT) stock and IT stock futures, since most IT stocks are strongly correlated to the dollar-rupee rate. Indian IT stocks tend to move up if the dollar gains. Another key basket would be the stocks and futures of corporates with high euro exposure such as Tata Steel, Tata Motors, Tech Mahindra, Bharat Forge, etc. These stocks have high sales into the euro region and tend to gain if the euro moves up.

The author is a technical and equity analyst

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