Odds of A Fed Rate Cut In September Rise

The rupee traded in a narrow range and closed at 83.54 in the week ending July 12. Dollar demand from importers and a weak yuan weighed on the rupee. However, a decline in the dollar index, lower crude oil prices and net FPI inflows (totalling USD 0.7 billion, including 0.3 billion in debt) offered some support.

The dollar index fell by 1% during the week to around 104 as odds of a Fed rate cut in September increased due to easing inflationary pressures in the US. Consumer price inflation continued its downward trajectory and declined for the third consecutive month to 3% YoY (year-on-year) in June. This figure marked its lowest level since June 2023 and came in below market expectations of 3.1%. Additionally, consumer inflation expectations for both the one-year and five-year horizons also eased.

Fed Chair Powell's Congressional testimony reinforced expectations that the Fed was moving towards its first rate cut. He acknowledged the cooling labour market and decreasing inflationary pressures and cautioned against maintaining a restrictive monetary policy for too long, citing potential risks to economic activity and the labour market.

Weakening consumer sentiment further strengthened expectations of a rate cut, with the University of Michigan consumer sentiment index falling for the fourth consecutive month in July, to its lowest level since November, well below forecasts.

Brent crude oil prices ended the week 2% lower, after four weekly gains. Talks of ceasefire between Israel and Hamas offered support along with expectations that Hurricane Beryl will not damage oil infrastructure in the Gulf of Mexico. Lower crude oil imports in China and a drop in consumer sentiment in the US also kept oil prices in check and reversed gains from a larger than expected decline in US crude oil inventories.

The Chinese yuan remained near its lowest level since November 2023 amidst monetary policy divergence with the Fed and concerns about China's growth prospects. Inflation in China remained subdued due to weak demand, with consumer prices falling to 0.2% YoY in June and producer prices contracting for the twenty-first consecutive month. China's imports also declined by 2.3% YoY in June, missing expectations of a 2.8% growth, indicating weak domestic conditions.

The euro, British pound and Japanese yen strengthened by 0.6%, 1.4% and 1.8% respectively against the dollar last week. The gains in euro were relatively limited as policy uncertainty in France persists as the country remains without a government. Hawkish comments from Bank of England officials and stronger than expected GDP in May supported the pound, while the yen strengthened due to likely intervention by the Bank of Japan.

Looking ahead, in the upcoming week, US retail sales data will be closely watched. Data is expected to show cooling in consumer sentiment. The focus will also be on the US elections, with higher chances of a Trump presidency following the first presidential debate and his attempted assassination. The increasing likelihood of a Trump presidency may push the dollar slightly higher.

Fed Chair Powell is due to speak at the Economic Club of Washington DC, where investors will seek further insights into his assessment of economic conditions.

The European Central Bank is expected to maintain its policy rates on Thursday, following a 25bps easing in June.

The Third Plenum in China, a key meeting of top Chinese officials, will also be in focus. However, the market is not expecting announcement of any major sweeping reforms. Separately, data released early Monday showed that China's economy expanded by 4.7% YoY in Q2, missing the 5.1% forecast and slowing from 5.3% in Q1. Weaker than expected GDP growth is likely to weigh on the yuan and consequently put pressure on the rupee.

Domestically, bond yields could see a slight increase following an uptick in consumer price inflation to 5.1% YoY in June from 4.8% in May, surpassing market expectations. Concerns persist over high inflation in certain food categories, including vegetables, pulses and cereals. Additionally, RBI Governor Das emphasized last week that it might be premature to talk about rate cuts as current inflation level remains above the targeted 4% and economic growth remains robust.

We expect the USD/INR to trade between 83-83.7 in the near term. While a weak yuan and a potential rise in the dollar index may weigh on the currency, an expected gradual increase in FPI inflows following India's inclusion in JP Morgan bond index should offer support. RBI is likely to intervene, as needed on both sides, to limit any rupee volatility.