One effect of the targeted Fed Funds rate being cut to between 0% and 0.25% has been a reversal in dollar strength. The rupee rose to a one-month high on Wednesday.
This has little to do with India-specific factors—the US dollar DXY index, which measures the strength of the dollar against a basket of currencies, has fallen from 88.46 on 21 November to 79.75. The latest bout of rate-cutting has just pushed the dollar down a bit more.
The reasons for dollar weakness aren’t too difficult to find. One is that the four-month rally in the dollar was too fast and the dollar is just catching its breath. Other forecasts suggest that with the Fed pumping out vast amounts of dollar liquidity, the currency will depreciate in future. Yet others say that the demand for dollars had risen because of its safe haven status and, with a measure of sanity returning to the credit markets, that demand may weaken.
But Morgan Stanley economists Stephen Jen and Spyros Andreopoulos argue that dollar strength will continue in the new year and the recent dollar weakness is due to “general reduction of risk-aversion (consistent with stable-to-buoyant equity markets) and unwinding of existing FX positions” as the trading year winds down. Besides, other central banks too will be forced to follow the US and cut rates, which should support the dollar.
In India, that expectation has already pushed down the yield on the 10-year government bond considerably. But there will also be other benefits—if the dollar remains weak, that will remove the need for the RBI to sell dollars and suck up rupees and will therefore support liquidity. As for stocks, the rate cut does little—the effective Fed Funds rate has in any case been below 0.2% since 5 December.