US bond yields unlikely to rise much from current levels; impact on rupee will be limited


Even though the day-to-day fluctuations in the dollar-rupee can be due to a plethora of factors but the big trends in the currency is caused by a handful of drivers such as foreign capital flows like FDI, FPI, debt-related flows, speculative positioning, and RBI intervention.

Oil prices have risen significantly from the single-digit levels to now mid-60s in Brent grade. However, the rise is from exceptionally depressed levels of last year and has not reached a threshold where it can become a headache for Rupee. It has been observed that the correlation between oil and USD/INR is quite fluid, as evident from the chart.

High oil prices tend to adversely impact USD/INR when there is US dollar tightness in the money market. In other words, a cocktail of Fed tightening US money supply and rising oil prices, as it occurred during 2018, becomes a perfect storm for Rupee. We are not there yet. US Fed and US government, both, are using all available options to keep USD liquidity high, via loose monetary policy and lax fiscal policy.

Therefore, in an environment of abundant US dollar liquidity, oil prices may have to rise quite a lot before it significantly drags down the Rupee.


High oil prices impact USD/INR via capital flows and changes in speculative positioning. High oil prices lower the disposable income of the citizens and that can reduce portfolio flows into the equity markets. FPI investors in bonds begin to sell their holdings as they see higher oil prices raising inflation levels in India.

Sensing this reversal in FPI flows, speculators, who are a major force in the onshore and offshore trading hubs, begin to cover their Rupee long and accumulate short positions in the currency. This interplay of portfolio flows and speculative position is what causes Rupee to react negatively to high oil prices.

Currently, speculators are buying Rupee due to the high forward premium. USD/INR trades at a premium in the futures month over spot price due to Indian interest rates being higher than the US. High forward premium induces large speculators to sell short USD/INR in the forward or futures and roll it forward on expiry.

They earn from the decay in premium as the futures price converges with the spot. Additional gain accrues if the USD/INR spot declines in value or in other words, Rupee appreciates against the US Dollar.

Currently, the forward premium in percentage terms over spot has reached four-year high, incentivising speculators to sell USD/INR in the futures/ forward market. RBI has played a significant role in preventing a rapid appreciation of rupee. It is estimated that they may have bought over $ 160 billion since June of last year, via spot and derivative markets.

Even though oil prices have not reached levels where they can threaten Rupee but US bond yields have. We got a glimpse of a sharp depreciation of the Rupee against the US Dollar last Friday, when the local unit depreciated by more than 2.2 percent, fastest since August 2013.

Rising yields can reduce FPI flows into India making the Rupee vulnerable to a long liquidation from speculators. Having said that, the silver lining remains the fact that this time the rise in long-term yields has occurred not on the back of Fed policy tightening. Therefore, as long as US Federal Reserve remains committed to low rates and QE, we do not expect US bond yields to rise much from here and hence their impact on Rupee will be limited.

Over the next 2/3 months, Indian Rupee can remain strong against the US Dollar. It can even test levels of 71.50.

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