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Take advantage of weak dollar, reduce unhedged rupee exposures

US President Donald Trump made a slew of pronouncements against free-trade agreements and immigration, in the first week since his inauguration.

On trade, he announced the withdrawal of US from the Trans Pacific Partnership (TPP). He threatened US automakers with tariffs on imports. He has reopened the North American Free Trade Agreement (NAFTA).

On immigration, besides declaring his intent to build the wall along the US-Mexican border, he has banned visitors from seven middle-eastern countries for 90 days, and reduced the intake of refugees for the year.

At this pace, geopolitics could overtake economic data as the critical market driver.

Markets expectations for this year continues to toggle between two themes. The base view is that reflation in the US will dominate. The US economy is reasonably strong, with low unemployment, robust asset markets, low household debt, and record levels of cash with corporates. President Trump’s promised tax cuts and infrastructure spend could spur growth, inflation, and more rate hikes in the US than budgeted. This could spur further US-dollar strength, and support trade and growth globally.

There is a less benign scenario, dominated by global vulnerabilities. Trade wars and domestic populism could hurt global growth. China has a stretched banking system, with outstanding loans of 2.5 times China’s GDP. Europe continues to fend existential questions about political and economic institutions. If any of these vulnerabilities were to flare up, global trade and growth would be threatened. US dollar may still strengthen though, this time as a haven currency.

While all roads appear to indicate a stronger US dollar, the market-price action since the beginning of the year has belied these views. US dollar is weaker by 2.5% this year, and volatility indicators have dropped significantly. Likewise, despite all the uncertainty of a Trump presidency, Dow Jones is at all-time highs, and VIX, the indicator of volatility in the Dow Jones Index is at multi-year lows of 12.5%.

This serves to emphasise the importance of market positioning, as a crucial determinant of price movements. Even today, the market is positioned for US-dollar strength. One sided markets tend to move in the direction of pain in the short run – in this case, US dollar weakness. However, the arguments for stronger US dollar in the medium run remain robust.

Given rupee is overvalued 17% in Reer terms, and the overhang of unhedged currency exposures, we would be well advised to reduce unhedged rupee exposures, taking advantage of any short-term US dollar weakness.

The writer is regional head of financial markets for Asean and South Asia of Standard Chartered