With inflation running around 40-year highs for some time now in the US, the Fed has already hiked its key benchmark rates by 25 basis points in March and speculation is strong that the central bank will follow it up with multiple 50-basis-point hikes starting as early as next month.
The prospect of higher US interest rates has pushed up yields on the country’s bonds, making the returns on those instruments more appealing for global investors and correspondingly leading to more demand for the dollar.
The intensifying conflict between Russia and Ukraine has also contributed to the dollar’s strength as the global economic upheaval caused by Moscow’s invasion has sent investors rushing to the safety of the greenback.
Typically in an environment of risk aversion, investors prefer debt instruments over equities as the former are considered to be safer.
A clear-cut way in which a stronger dollar index affects domestic financial markets is the depreciation of emerging market currencies, including the Indian rupee.
A weaker rupee erodes the returns that foreign portfolio investors earn from their investments in Indian debt and equity instruments and therefore the possibility of the US dollar index strengthening further poses the risk of outflows.
“Dollar index in the last few sessions has been inching higher on the back of prospects that the Federal Reserve could adopt a more aggressive rate hike process than estimated earlier,” Gaurang Somaiya, Forex & Bullion Analyst, Motilal Oswal Financial Services said.
“Going ahead, hawkish stance by the Federal Reserve is likely to extend gains for the greenback. We expect the dollar index to test levels of 103.20 in the near future and downside could be restricted to levels of 97.20.”
After closing at 96.71 in February, the US dollar index on Tuesday touched a high of 101.02. The index was last 100.77.
Meanwhile, yield on the 10-year US government bond yield, a global benchmark for fixed-income, has shot up 74 basis points over the last month and is currently within a stone’s throw of the 3 per cent mark.
Amid the global risk aversion, so far in 2022 the Dow Jones Industrial Average has declined 5 per cent and that weakness has spilled over into Indian stock markets, with the BSE Sensex and the Nifty50 having shed 2 per cent each over the same period.
Overseas investors, who from October 2021 to March 2022, had embarked on their largest sales of Indian stocks since the Global Financial Crisis of 2008, have tentatively begun to show signs of interest again in April, with net purchases of around Rs 2,000 crore.
So far in 2022, FIIs have net sold equities worth Rs 1.1 lakh crore.
With the dollar index strengthening the way it is, foreign players could once more make a beeline to exit stocks if the rupee were to show volatility.
While the RBI’s large foreign exchange reserves provide protection from excessive volatility in the exchange rate, analysts do not rule out episodes of turmoil as the Fed starts hikes in earnest.
The rupee has depreciated 2.5 per cent against the US dollar so far in 2022.
“It is also possible that we could see a fresh round of FPI outflows as the Indian rupee depreciates. It is only domestic money right now that is supporting the markets,” Nirmal Bang, Head of Equity Research, Retail, Sunil Jain said
Another offshoot of the global dollar strength is that it makes imports of dollar-denominated commodities such as crude oil more expensive.
As it is, crude oil prices have surged to multi-year highs following the Ukraine war and the strengthening dollar would just go on to add further pressure to India’s trade deficit, given the country’s huge dependence on oil imports.
Oil companies and other import-oriented firms stand to lose in this situation.
For domestic stock markets, the steady rise in the dollar index is one amongst several headwinds, analysts said.
“As of now, if we take the Indian market, the dollar index is definitely one factor but apart from that, there is a lot of inflation; corporate results are not likely to be what they were in the past so that will have an impact,” Jain said.
It is not only equity markets that have borne the brunt. Higher US bond yields have also wreaked damage on the sovereign bond market.
With investors fearing an exodus of overseas money from Indian bonds to US bonds, yield on the domestic 10-year benchmark bond has surged 73 bps so far in 2022. Bond prices and yields move inversely.
The rise in sovereign bond yields will lead to higher cost of borrowing across the economy, including corporate borrowing, as government debt yields are the benchmarks for a vast variety of credit products.