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business newsIndian Rupee and Limits to the Carry Trade
The Fed has insisted it has printed a reserve currency without inflationary consequence. India would beg to differ, and all those who chased over to the BRIC markets will discover the carry trade has its limits.
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The rest of the world, as I noted in the case of Brazil, responded with capital controls, taxes on investments, and pleas falling upon deaf ears for the US to cease and desist. Dr. Frankenstein could fill them in on the rest of the story regarding the relative ease between creating a monster and controlling it. Let’s see how this story is playing out in another member of the BRIC quartet, India, using the same format from last March.
Hang On, Rupee
The Indian rupee (INR) had been rallying since the US went to its zero interest rate policy in December 2008. The currency, plotted inversely, rose as the US money-market yield curve rose relative to its Indian counterpart. These expected interest rate differentials are measured by the forward rate ratios between six and nine months (FRR6,9). These are the rates at which we can lock in borrowing for three months starting six months from now, divided by the nine-month rate. A steeper yield curve normally was associated with expectations for higher interest rates and therefore was considered bullish for a currency, but that changed as the world shifted to “perma-expectations” for higher US interest rates.
The INR is weakening now as India is forced to keep raising interest rates to combat inflation of 9.64% for urban non-manual workers. Those higher interest rates should increase the carry rate return for borrowing USD and lending INR, but a funny thing has happened since early October: The excess carry return has turned negative and Indian stocks have started underperforming US stocks. Indeed, since October 4, 2010, American stocks have outperformed Indian stocks by 26.8% in USD terms. You deserve a BRIC today.
The only good news from an Indian financial market perspective is this relative stock market underperformance should lead to lower long-term rates in India relative to the US through the first half of 2011. Higher short-term interest rates often slow an economy and move a yield curve toward inversion; the US yield curve remains extremely positively sloped.
The Federal Reserve has insisted it has done something without precedent in human history: print a reserve currency without inflationary consequence. India would beg to differ, and all those who chased over to the BRIC markets in search of return will discover the carry trade has its limits. Mae West once proclaimed in another context, “Too much of a good thing can be wonderful.” Not if it is money printed without regard to the consequences.
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