Trading strategies for a falling rupee

Real rupee interest rates would reduce if domestic inflation rises and the RBI doesn't raise policy rates

For the past year or so, the rupee has seen a sustained uptrend versus the yen and  dollar, though its performance versus the euro has been less convincing. On September 1, 2016, the rupee was trading at 66.96 to the dollar and 74.66 to the euro and 64.78 to yen. In early August 2017, it hit a high of 63.63 versus the dollar, high of 68.25 to euro in April 2017 and a high of 56.38 to the yen in July 2017.

But, we might have seen the beginning of a trend reversal in the past week. The rupee has started sliding as fear mounted about confrontation between North Korea and the US. In 10 sessions, the rupee has lost about 2.25 per cent versus dollar and it was trending below Rs 65.30 on September 26. The rupee had lost about 0.9 per cent against the euro as well. But, the rupee had gained versus the yen because Japan is in the direct line of fire for North Korea. Brexit makes the pound a special case, the Bank of England is expected to hike interest rates and the rupee is down 4.5 per cent versus the pound.

There are fundamental reasons why the rupee might slide more versus euro, pound and above all, the dollar. Real rupee interest rates would reduce if domestic inflation rises and the Reserve Bank of India  (RBI) doesn’t raise policy rates. If the dollar, pound and euro yields rise at the same time, the differential between rupee yields and dollar/pound/euro yields will narrow, making carry trades less attractive. The rupee is also being hurt by fear of a rising fiscal deficit and higher current account deficit. That adds to currency risk.

A sharp trend reversal could have multiple consequences. Some are positive. A weak rupee could aid exporters and afford protection to manufacturers competing against cheaper imports. But, a weaker rupee also means higher inflation, given dependence on fuel imports.

One key factor in keeping the rupee strong has been enthusiastic foreign portfolio investment (FPI) buying. If FPI attitude changes, pressure on the rupee will increase and might cause a feedback loop, generating yet more pressure if higher inflation triggers FPI selling. Corporates with overseas debt exposures could also be stressed.

Going long on dollar in dollar-rupee futures is an obvious trade for those who can handle high leverage. Currency options are another possibility due to the limited downside. However, the rupee is a “dirty float” because RBI can intervene anytime. The central bank has a big war chest.

Another trading possibility is to target Indian corporates with external commercial borrowings (ECBs), especially ECBs requiring repayment in the near future. There's loose talk and wild rumours about potential ECB defaults in October. That might not happen but there could be speculative shorting of companies with ECBs.

A less risky play is betting on a technical revival in the prices of information technology (IT) stocks. IT stocks are hyper-sensitive to rupee fluctuations and IT has underperformed through the past year. Fundamentally, margins have flattened and the IT sector is struggling to generate revenue growth. A weaker rupee might add something to bottom lines and even help with constant-rupee growth.

Among IT majors, HCL Tech (up 11 per cent) and Wipro (up 22 per cent) are the only stocks that have delivered acceptable returns in the past year compared to the Nifty (up 14 per cent). If there is an revival of interest in IT stocks, driven by a falling rupee, the sector's underperformers might be even bigger beneficiaries. Mindtree, Infosys, TCS, TechM, etc, could all be candidates for defensive rebounds.