Globally, government bond yields have been rising for more than a year as central banks raise interest rates at an unprecedented pace to combat inflation.
The 10-year US Treasury yield, the global bond benchmark, has soared from 1.91% at the beginning of 2022 to the current 4.33%, and the gap with India’s 10-year Treasury yield has narrowed from around 4.9% to the current 2.87%. Early 2022.
While the yield differential is not the only determinant of exchange rates, there is a significant inverse relationship between the India-US yield differential and the USD-INR currency pair, i.e. when the yield gap narrows, the USD-INR increases (or the rupee ) depreciation). The correlation between the two since 2011 is -0.79.
this is different
This time, however, the trend appears to have paused. The rupee remains stable against the US dollar in 2023, even as the yield gap between India and the US narrows. In just one year, the rupee has depreciated by only 4%, although the yield gap has narrowed by about 135 basis points (down 31%).
Three key factors
This time, three factors appear to be keeping the rupee stable.
Throughout this year, the Indian market has experienced significant foreign capital inflows.
Net foreign portfolio investment (FPI) in India, including equity and debt, totaled about $19.6 billion as of the end of August, according to NSDL (National Securities Depository Ltd) data.
Secondly, forward premiums on the USD/INR pair have declined. In early July, the 12-month forward rate of the US dollar against the Indian rupee fell to 130 paise, the lowest level since September 2008 when it touched 128 paise.
Lower forward premiums mean the market does not expect the rupee to depreciate significantly. To some extent, the higher the forward premium, the lower the foreign exchange risk for the carry trader. The current premium is 146 paise, which is prohibitive for participants.
Finally, the inflation gap between the US and India remains unusually narrow this time around. Historically, inflation in the United States has been significantly lower than in India, which has resulted in interest rates in India being significantly higher than in the United States. However, this time it was not the case.
The rupee has not strengthened even amid dollar depreciation, despite capital inflows and favorable inflation differentials providing downside cushion. This year, the dollar fell in March and June-July. But the rupee did not rise against the dollar. In fact, there was a slight decrease.
“The RBI’s effective intervention in USD/INR buying and selling has helped stabilize the USD/INR pair,” said Anindya Banerjee, Vice President, Currency and Rates Research at Kotak Securities.
future risks
The RBI may buy dollars and sell rupees during periods of rupee appreciation so that the benefits of dollar depreciation are not fully transferred to the Indian currency.
While the current outlook for the rupee seems good, there are potential downside risks.
“The two main concerns are a longer-term strengthening of the dollar, driven by the Federal Reserve’s decision to keep interest rates higher for longer, and rising oil prices, which could impact India’s trade deficit and push up inflation,” Kunal Sodhani said. Vice President of Shinhan Bank Global Trading Center.
Last week, the U.S. dollar index hit a six-month high of 105.4 and Brent crude futures soared to $94 a barrel for the first time since November. There is a significant risk that crude oil prices will surge further as Saudi Arabia and Russia adopt production cuts.
Additionally, concerns over global economic growth may shift sentiment towards risk aversion, which may lead to a sell-off in the rupee. Nonetheless, any potential downward trend in the rupee is likely to be tempered as the Reserve Bank of India can provide a buffer through its large foreign exchange reserves, which are currently close to a record high of $595 billion.
