MPC,EuroandFreelunches

This week is going to be an important news filled week. We will see the MPC meeting in India and from US we will have the NFP data. In the middle of it there is some news expected on the Brexit front also. Though the UK Euro saga has been going on for the last four years, it looks likely that as the date of final Brexit nears, the parties will reach an amicable deal avoiding a no deal chaotic Brexit. The optimism also reflects in the currency levels as both Euro and Pound sterling have appreciated. The Euro surged past the important level of 1.20 against the USD trading 1.2075 currently.

Apart from the Brexit, markets continued to be enamoured by the news on the vaccine side as the vaccine makers applied for emergency approvals from the European medical regulator. This was again construed as another shot in the arm for the belief that the vaccine is effective and can make the economy healthy quickly. Markets obviously would discount it today rather than waiting for it to actually happen. US Fed Chief Jerome Powell, in his testimony to senate, sounded much more sober and sounded the alarm on the vaccine speed and distribution. He was also cautious regarding the surge in new cases and the possibility that unemployment may remain elevated. The outgoing treasury secretary Steve Mnuchin though painted a more upbeat picture of the recovery in his testimony. The sober assessment by the Fed actually is not a concern for the markets as it signals that current conditions of ample liquidity are here to stay. Also once the new treasury secretary, with a track record of being dovish, takes over from Mnuchin, the Fed is expected to find a perfect mate on the fiscal side too.  

Now the Fed can decide to keep printing money but the implications of the same are not limited to the geographical boundaries of the US. Like the flowing water finds its own level, liquidity also finds its way to higher yields. In the WSS report published last Friday, the RBI reserves are shown at an all-time high of USD 575 bn having grown by close to USD 100 bn since April. No wonder this was around the same time when the Fed pressed its pedal hard on the emergency virus response. Many other economies also received those dollars. As nothing is simple in such an interconnected world such dollar surge results in appreciation of the local currency resulting in buying of dollars by the CB to keep the local currency from appreciating. This in turn raises the liquidity in the local market which in effect forces the CB to buy bonds through OMO. The price it pays on those bonds in effect becomes a price which the local CB pays to allow the Fed to continue with its money printing policies.

Author James Rickards in his book Currency Wars tackles this issue in detail and explains how under the old Bretton Woods system tethered to gold this kind of free lunch would have been impossible. We will come back to that point in a later note as we have run out of space today. But is important to recognize here is that the book was written in 2011 and since then we have seen one complete decade of low interest rates and easy money policies in the developed world. It is no surprise that many CBs across the world have seen the Fx reserves rise either willingly or unwillingly.

Domestically, the rupee saw appreciating momentum yesterday towards 73.50 levels in the absence of any concerted buying by the local public sector banks. As “risk on” continues this might be one trend which is likely to persist. The interesting thing to see will be the levels which will be guarded in its upward march. On the bond side markets are waiting for the MPC policy on Friday. The liquidity situation which has driven the short term rates below reverse repo rates might get addressed. The benchmark 10 year bond is trading at 5.93 currently.