Rupee could drop to 69, but dollar still the king

The retracement in the US dollar (USD) strength since Trump's victory in November has surprised and frustrated the market. Speculative net long positions in the US dollar has retreated significantly despite strong flow of economic data from the US- economic surprise index is at its highest since 2012- and a more hawkish commentary from the Federal Reserve (Fed) has indicated three hikes in 2017.

Still, these foreign exchange (FX) market trends in early 2017 (rupee strengthened to 66.83 on the last trading day of the week) in our view should not lead to complacency. A whole host of reasons still justify a case to remain wary and prepared for a stronger US dollar over the remainder of 2017.

First, even as clarity on Trump's policies, especially on his fiscal stimulus plan are yet to emerge, it will be premature to conclude that Trump is reneging on his campaign promise to boost economic growth. Additionally should US take a protectionist stance towards global trade it can significantly undermine emerging market currencies including Indian rupee. Second, another shock success of say the far right candidate in the impending French elections in April-May can act as a strong reminder of a world which is turning more nationalistic and protectionist.

Third, positive seasonality which supports Asian (ex Japan) / AXJ currencies in Q1 of every calendar year is likely to fade away in Q2. The adverse swings in seasonality in Q2 especially in month of May and June are particularly marked for the rupee. Given that Fed is also expected to deliver a hike in Q2-2017 (March hike in market's view is still a low probability), the likely combination of a higher USTs yield, stronger US dollar and negative seasonality has the potential to push rupee to reverse most of its recent gains. Even after adjusting for base year and productivity differential, the rupee remains overvalued by 4-5%. Thus some course correction over the next quarter should not come as a surprise.

While we do not expect the Indian currency to weaken significantly towards 70, a move back towards 69 by end of the year is still likely. Manageable current account deficit, strong foreign direct investment, better growth prospects and still high-real yields are likely to prove supportive of the rupee and leave it as one of the best performing currencies amongst its peers. Still these will not prove sufficient enough to overcome the theme of a stronger US dollar.

The writer is head, South Asia Economic Research (India), Standard Chartered Bank, India