FX options signal weak rupee outlook on Fed view, Middle East crisis

Mumbai: Currency options in India are signalling the rupee is more likely to depreciate as investors fret over the impact of a delay in U.S. rate cuts and an escalation of the Middle East crisis.

The cost of making a bet that the rupee will weaken against the U.S. dollar vis-a-vis it rising is now the highest since September, as indicated by the 3-month risk reversals.

Risk reversal expresses the difference in what investors are willing to pay for betting on the upside relative to the downside on an asset. For the dollar/rupee, the 3-month risk reversal is at +0.5%, meaning an option that grants a right to buy the dollar/rupee costs more than the right to sell.

On Tuesday, the rupee hit a record low of 83.5350 to the dollar, prompting intervention from the central bank. The 1-month implied volatility on dollar/rupee rose to the highest since mid-November.

In January, when investors were piling on bullish wagers on the rupee, the 3-month risk reversal had dropped to as much as -0.2%.

"Things are a lot different now than they were in January from the point of view of what the Fed is expected to do. The whole of the EM complex has been impacted, not just the rupee," a portfolio manager at a Singapore-based hedge fund said.

In January, investors had priced in six-to-seven rate cuts by the Federal Reserve this year on expectations that inflation will ease to align with its target.

However, the last three U.S. inflation readings have surprised on the upside, prompting a hawkish repricing of the Fed path. It is now expected to deliver only two cuts in 2024.

The dollar has rallied 4.8% year-to-date to 106.30 and Treasury yields have climbed, pressuring Asian currencies.

Iran's attack on Israel has compounded the rupee's woes.

A further escalation could see oil prices rise, which would be a worry for the rupee, Dhiraj Nim, forex strategist at ANZ, said.

The rupee will weaken more if dollar index climbs past 107 but the Indian central bank should smooth the decline, Nim said.