Rupee hits 10-month low: Will it cause a correction in stock market?

The Sensex and Nifty are just off by a couple of percentage points from all time highs, while the ten-year bond yield is at a three and half year low. The Indian Rupee (INR) is trading just off 3% from all time lows against the USD. The INR is trading at levels of Rs 56.18 to the USD as of 28 May 2013, down 4% from levels of Rs 53.10 seen in early February. The Sensex and Nifty have gained over 2% while the ten year bond yield has dropped by 55bps since early February.

The INR depreciating against the USD even as equities and bonds are seeing strong rallies is definitely a factor to mull on. Sustained fall in the INR against the USD could even cause a deep correction in equity and bond markets if there is no plausible explanation for this trend. So why is the INR seeing weakness even as equities and bonds are rallying? Let us try and find a reason for this.

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[caption id=“attachment_805069” align=“alignleft” width=“380”] The INR depreciating against the USD even as equities and bonds are seeing strong rallies is definitely a factor to mull on. Reuters[/caption]

One theory that is emerging is that the Euro weakness is feeding into INR weakness on risk aversion trends. The Euro has fallen by 4.5% against the USD since February on the back of the relative strengths in the economies of the US and Eurozone. US economy is improving with jobs being added and unemployment rate is coming off while the Eurozone is seeing record unemployment and recession.

The Euro weakness theory does not really work when looking at the movements in INR peer countries. Brazilian Real and Korean Won have fallen by over 2% since February but these countries have issue of growth and geo political tensions that could have been the reason for the currency weakness. The Thai Bhat has hardly moved since February while the Indonesian Rupiah and Philippines Peso are down by just 0.3% and 0.8% respectively. Hence despite Euro weakness, there are no signs of fear driven risk aversion trades.

India’s sharp rise of 72% in trade deficit to $17.76 billion in April from $10.3 billion seen in March may have turned sentiments on the INR. Current Account Deficit (CAD) was at record 6.7% of GDP in the third quarter of 2012-13 and given April trade deficit numbers, markets are worried about CAD not coming off as expected. However capital flows at $5.9 billion in the first two months of this fiscal have been robust and the CAD is being financed by capital flows as seen in the last couple of years.

The fall in oil and gold prices that are off 13% and 27% from highs seen in April 2012 and August 2011 respectively is expected to help bring down the CAD as oil and gold imports account from around 45% of India’s total imports.

RBI has an outstanding of $11 billion in forward sales as of end March 2013. The central bank has not given the unwinding schedule and if some bunched up forward sales are expiring in May, the unwinding of the May contracts could have led to the rupee weakness.

Unwinding of USD/INR shorts by the market could have also caused the INR fall. The market seeing strength in equities, strong capital flows and fall in gold and oil prices may have gone short the pair and seeing the sudden reversal in trends is now forced to cover the shorts. The short covering could have lead to a self fulfilling upward trend in the USD/INR pair.

Can equities and bonds reverse trends on INR weakness?

The possible explanation for the INR fall has been outlined above. The question is will this fall bring about a market correction. Will the Sensex and Nifty fall from highs and bond yields rise from lows?

The answer is yes, the market may choose to sell equities and bonds to take profits at higher levels citing rupee weakness as the reason.

However will the broad upward trend in equities and downward trend in bond yields reverse? The answer is no as there are enough number of fundamental factors driving strength in equities and bonds including falling inflation expectations, surplus cheap liquidity in the global system, weak global commodity prices leading to correcting in current account and fiscal deficit and possibility of an economic recovery going forward.

Keep an eye out for market correction but do not close your eyes to the broad positive trends.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com a web site for investors