Reality check: Is market's expectation of rupee skewed?

17 February, 2023

I see a general trend across market participants of a strong recency bias when it comes to the Rupee’s performance against the dollar.

In my recent interactions with corporates, especially exporters, I could sense a bit of complacency when it came to the outlook on the rupee. There seems to be a general perception that the rupee is bound to weaken. Lately, rupee has underperformed because of positive real rates in the US, pressure on CAD, and the idiosyncratic Adani saga. We track many of these factors very closely in our own model and that too is still pointing to moderate bullishness for USD-INR in the short term.

I completely understand their bias given the recent macro themes and narratives. It is however important to not miss the forest for the trees. Data suggest that rupee does not depreciate as much as the carry and that selling the dollar against the rupee on a rolling basis does pay off.

In my experience of 20 years, one always makes money in USD while selling USD since carry (historically has been an average of over 4%) is always in your favour.

Over the last few years, this has been the case even more so as the current RBI regime has been focused on containing volatility while engineering calibrated depreciation of the rupee on a trade-weighted basis.

Under the rolling hedge strategy, there could be a year or two when you have to pay M-T-M but broadly the strategy rewards you to the tune of 1-1.5% on your bookings.

To illustrate it more simply - If you run a Rs 1,000 crore rolling book you generally make around 10 cr using the method -- i.e. Rs 50 to 75 crore in a block of 5 years.

In a block of 5 years whenever the Rupee depreciates 8-10%, recency bias typically tends to creep in. Exporters are skeptical and hesitant to hedge.

They tend to deviate from the systematic hedging strategy. Hedge ratios get reduced (for an exporter) and the company is stuck and suddenly finds itself behind the competition.

This generally happens due to fear (imagining the worst), recency bias, and noisy headlines. Old market participants will be able to relate to this. Rupee has already depreciated by over 10% over the last 12 months.

Exporters are reluctant to hedge currently as they see considerable macroeconomic and geopolitical uncertainties and the forward premiums are extremely low, around 2%.

I could sense complacency among treasurers, CFOs, and decision-makers.

The advantage of using the statistical or quantitative approach is that it enhances the probability of making the right decision.

The fear part can be eliminated using Plain Vanilla Options or (risk reversal). Position sizing should be appropriate based on your net worth and your business orders and expectation.

My understanding is that as soon as we see the first signs of inflation receding, India’s CAD improving or vols dipping we will suddenly see a massive appreciation of the rupee. (The January trade deficit has already surprised on the downside, coming in at USD 17.75 billion).

Stop losses getting triggered on a break of crucial levels could possibly result in accelerated appreciation of the rupee, maybe even below 80 and the RBI may let the rupee appreciate for once to shatter the complacency.

I feel the dollar weakness globally has already started a couple of months back and it's only a matter of time rupee will catch up.

The strength of the rupee will be very fast and my understanding is based on actual data and how the overall market is positioned.

Most of the export companies who have changed their historical hedges based on recent phenomena could possibly be trapped.

At IFA we follow a strict model based on the risk management policies where we define an upper and lower band (which are in turn linked with our proprietary back-tested hedge model) which changes daily based on actual data and hedges are placed accordingly.

It makes life simpler and more systematic for us and our clients. Interesting times ahead, meanwhile park your money in long-duration debt mutual funds I think it may pay off well - may be better than equities.