It is premature to assume that the EUR’s overnight pullback was driven mainly by markets pricing out a peace dividend due to US President Donald Trump’s diplomatic outreach to EU leaders in support of his efforts to broker peace between Ukraine and Russia. First, we are cautious about attributing the decline in EU defence spending stocks solely to hopes for a peace settlement, which was also likely driven more by the souring risk appetite due to the sell-off in US AI-related tech stocks. Until a formal ceasefire or concrete agreement is reached, markets may be acting on hope and expectations. In normal circumstances, progress towards peace in Ukraine would be supportive of risk appetite and the EUR, as reduced geopolitical premiums lift confidence in the Eurozone’s outlook and lower defence outlays ease worries about increased fiscal expenditures.
Second, investors have grown wary that Fed Chair Jerome Powell, who is speaking at the Fed’s Jackson Hole Symposium on August 22, may push back against the market’s easing bets. Tonight’s FOMC Minutes for the July 30 meeting should confirm the growing divide within the Fed, where two Trump-appointed Governors dissented and voted for a cut. While the majority stood by the decision to hold rates, many members appear open to reductions later this year, depending on incoming data. Powell’s speech is significant because it offers insights into how the weak US jobs report on August 1, shortly after the FOMC decision, has tilted the balance towards an insurance rate cut while warranting vigilance against tariff-led inflation.
Meanwhile, the INR’s recovery has attracted attention. For a second time this year, USD/INR is retreating from the ceiling of its 84-88 range established in October 2024. Despite the Reserve Bank of India’s currency interventions, foreign reserves have risen, and foreign investors have recently returned to Indian stocks and bonds. We estimated the currency pair’s fair value at 85-86, based on its linear relationships over the past year with the weaker USD Index (DXY), the negative US-India 10Y bond yield differential, India’s still buoyant stock market, and the significantly narrower 5Y credit default spread for Indian government debt.
We expect the following factors to support the INR. First, Standard & Poor’s upgraded India’s sovereign debt rating by a notch to BBB for the first time in 18 years. The decision was significant in shifting the investor narrative away from the shocking deterioration in bilateral trade relations with the US towards India’s structural strengths – strong growth, credible fiscal consolidation, and effective inflation management. Second, the RBI shifted to a neutral stance after its larger 50 bps rate cut to 5.50% on June 6. In contrast, we expect the US Fed to resume its rate-cutting in September from 4.25-4.50%, which should widen the policy rate differential in the RBI’s favour.
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