A Study of the Rupee vis-à-vis the Black Gold -27th May 2008

Chart 1

The chart 1 indicates that the overall secular trend of oil has been to the upside. It has been a steady bull run that was interspersed by short periods of consolidation.

Medium term: Corrective dips would find key supports at 100-115.So long as price action is contained above the pink line, dips would provide bidding opportunities to take the rally forward.

Long term perspective: Real estate, equities and commodities were the three major asset classes that simultaneously witnessed swift appreciation on cheap money and easy liquidity (spurred by the Fed cutting rates to 1% that existed until June 2004).Of which housing and equities have taken a reasonably decent round of correction in recent times. Commodities is the only asset class which is yet to undergo a significant correction. This is expected to occur when the Fed stops its easing stance and switches to a tightening mode on account of inflationary pressures which will most certainly come to haunt the US economy possibly in 2009 (fallout of rates being aggressive cut together with commodity led inflation)

Thus in short, it is still too premature to call it a top for the Bull Run in oil. Having said that, a temporary top may be in place to set in motion a correction to the above mentioned support levels .However for a confirmed trend reversal, 85 would need to be breached convincingly.

Chart 2:

The rupee in contrast has witnessed a more convoluted price action which has been a combination of prolonged periods of consolidation and swift reversals .One noteworthy characteristic of the rupee’s movement is that volatility is greatest at turning points and diminishes as the trend becomes established.

Chart 2 reveals four significant depreciation spells that have occurred between 2004 and now.

Chart:3

April-August 2004 : The Rupee depreciated from 43.30 to 46.50, an approximate 7.4% fall during this phase, the main trigger being the surprise outcome of the Indian general assembly elections at a time when global risk aversion was also generally high. This had resulted in a major sell-off in Indian equity markets. Oil prices moved from $34 to $47.

September - Dec 2005: Despite a relatively stable global risk environment, the rupee spurted from 43.50 to 46.50 levels. There was no single reason but a host of factors namely, scant portfolio flows amidst current account deficit, opening NDF arbitrage, trigger of overly-leveraged structures. Interestingly, oil prices declined from $70 to around $57 during the same period.

February- September 2006: This period saw the onset of the commodity market boom, which fanned a huge spike in global risk aversion over fears of rising global inflation and impact on global growth which led to a huge sell-off in emerging market equities. The dollar notched up approximately 6.8% gains as it briefly kissed the 47 mark .Oil prices surged from $58 to about $ 77 in this period.

April 2008 to…………

The credit crisis and fears over a severe recession in the US economy had resulted in a major spike in global risk aversion at the start of the calendar year. 30% of the market capitalization was shaved off in equity markets in a span of days. Since then portfolio flows have failed to pick up even as signs of retreating global risk aversion has been noticed. There has also been a perceptible decline in announcements of fresh private equity deals. So, in a nutshell, the volume of cross-border capital flows has dwindled over the last few months. Unabated rise in global oil prices did trigger in panic buying of dollars. It is however interesting to note from the above chart that the rupee maintained its poise under 40 when oil prices initially climbed to 119.5. The rupee’s rapid fall was when oil climbed yet again past 119.5 levels.

Other observations:

Even when the rupee staged possibly its best ever rally from April 2007 until sometime back gaining a terrific 11% against the dollar, oil continued its steady upward march rising approximately 67% from $59 to $100, posting thereby a clear negative correlation. This period also witnessed a copious inflow into the capital markets, which to a large extent determined the rupee’s fortunes.

Conclusion
The rupee’s recent behavior can be seen as a lagged response to oil prices generally exhibiting an upward climb in the past several months, it can be seen that markets have responded differently to apparently the same variable.

During rupee appreciation phase, the same increase in oil was viewed as the reason to keep rupee appreciated to tone down the import bill and thereby the trade deficit. Markets now turn a blind eye to this reasoning as the economic impact of high oil on growth and the trade deficit argument take centre stage.

Going forward...

As noted earlier, oil could witness a correction towards 100-115 levels, which could be accompanied by the dollar slipping towards the 41.50/75 territory. Performance of the domestic bourses in relation to FII flows will also set the near term direction for the domestic currency.