Goldilocks keeps the bears away

2024 has started on a somewhat unexpectedly upbeat note with fears of a sharp recession in major economies like the US receding. Moreover, there are nascent signs that the slowdown in Europe and China might be bottoming out after a fall last year. ?Latest IMF projections peg World GDP growth at 3.1% in 2024 – revised up from 2.9% estimated earlier. The biggest contributor to this slightly better global outlook is the continued resilience of the US economy despite the sharp interest rate increases by the central bank over the last two years.

Meanwhile, inflation has moderated across the advanced world as interest rates remain elevated and supply chain disruptions have eased. This combination of resilient growth and falling inflation has created the proverbial goldilocks scenario where things on the macroeconomic table are neither too hot nor too cold. Will central banks, including the RBI, cut rates then? Perhaps not immediately. Inflation across economies, while softer than last year, remains above central bank targets and uncertainty around the “last-mile descent to the target” is keeping central banks cautious. Moreover, tight labour markets and lingering geopolitical tensions are preventing global central banks from announcing a victory over inflation and easing monetary policy just yet.

Financial market investors have therefore pushed rate cut expectations forward. The US Fed is now expected to cut rates by 75bps (basis points) starting June 2024 compared to earlier expectations of 150-175basisps rate cuts starting March. Similarly, the European Central Bank is also expected to start its rate cut cycle not before the end of H1 2024.

In India, the RBI has signalled that imminent rate cuts seem unlikely with inflation still above its median target of 4%. There are a few exceptions – for instance, the Bank of Japan has just exited its decades long easy monetary policy stance by increase its policy rate in response to rising inflation in 2024 (current policy rate at -0.1%). Elsewhere, the PBoC (central bank of China) is expected to keep monetary policy loose to counter what seems like a prolonged slowdown.

What’s the currency bet then? ?The change in interest rate expectations has had an impact on currency markets in 2024 and is likely to remain one of the major drivers even going forward. Most notably, the repricing of the quantum and timing of interest rate cuts in the US has boosted the US dollar against both developed and Emerging Market currencies so far this year. This could continue in the near-term and it would take a rate cut by the US central bank, when it does happen, to significantly weaken the dollar.

Moreover, there are several risks that could also muddy the waters for financial markets. Most notably, with elections in major economies like the US, currency market volatility is likely to remain high. Moreover, while commodity prices behaved well thus? far, lingering geopolitical tensions pose a risk for supply chains and ?commodity prices.

In India, the economic narrative remains notably upbeat. Growth continues to print comfortably north of 7% -- much faster than its peers – boding well for investor sentiments and is likely to support both FDI and portfolio flows in 2024. Moreover, the inclusion of Indian bonds in the JP Morgan bond index (starting June) is likely to attract debt inflows to the tune of roughly USD 25 billion over the following ten months. The current account position (broadly the balance of trade in goods and services put together) also remains comfortable with support from healthy services exports. These factors bode well for the rupee over the coming months.?