Indian and ASEAN currencies have not moved quite as comprehensively as they did ahead of the last two Fed policy tightening cycles and hence it is unlikely that there will be no market reaction to the Fed’s next move, notes a report from UBS.
Edward Teather and team at UBS in their May 29, 2015 research report on “APAC Economic Perspectives” anticipates the Reserve Bank of India will cut its repo rate another 75bps by end calendar 2015.
Fed Funds Target rate could increase in September 2015
The UBS analysts compared the experience at the start of the last two initial tightening steps by the Federal Reserve viz.: the initial Fed Funds hike in June 2014 and the actual announcement of asset purchase tapering in December 2013. They note that in both cases, the anticipation of the beginning of a Fed policy tightening cycle led to an adjustment of return expectations and positioning such that Southeast Asian and Indian currencies weakened against the U.S. dollar:
Teather et al. points out that past experience, false starts and the loud debate over the exact timing and speed of Fed tightening implies it is unlikely that there will be no market reaction to the Fed’s next move.
Teather et al also note Indonesia’s currency has been the most sensitive to initial steps in both prior episodes of Fed tightening. The analysts’ metrics of liquidity indicate there is a good chance that it could prove the same this time round, both for structural and cyclical reasons. Thus the analysts believe the rupiah is most at risk from any adverse capital flows resulting from anticipated Fed tightening.
The analysts point out that cyclically, Indonesia’s current account – although narrowing – is still at a relatively wide deficit compared to history. That is unhelpful because it means Indonesia needs to attract capital flows of around USD 20 billion or more this year in order to finance domestic spending. They this need for capital reduces options should capital flows become more difficult.
ASEAN currencies – RBI could ease policy rates
Teather and team anticipates that the Bank Indonesia will avoid cutting policy rates any further until after the Fed’s initial move, while in India, the Reserve Bank of India may be willing to tolerate modest rupee weakness as part of the policy easing process.
Providing a rationale to support their views, the analysts point out that the upshot is that if their trend disinflation projection plays out in India, the inflation gap between the U.S. and India will narrow. The following figure captures the implied inflation and interest rate gaps if there is no change in Indian short term interest rates. They point out that the elevated gap between the interest differential and inflation differential (the grey shaded area) supports the notion that Indian interest rates have room to fall:
Turning their focus towards the impact of declining oil prices, the UBS analysts note the decline in the oil price certainly appears to have benefited the currencies of energy importing economies Thailand, Philippines and India over the last 12 months. However, they note energy exporters Malaysia and Indonesia – and perhaps by association Singapore – have seen their currencies depressed:
Considering current exchange rates and anticipating of policy tightening by the US Fed, the analysts have adjusted their foreign exchange rate forecasts. They anticipate ASEAN and Indian currencies will weaken ahead of the Fed’s initial rate hike in September 2015 before stabilizing:
The UBS analysts have also considered the risk from oil prices rising / falling more than anticipated or delay in Fed tightening. The following table depicts the implications for currencies of alternative Fed and oil price scenarios:
