Can the divergence between DXY and USD/INR pave the way for rupee’s return to 86.50?

Currency markets are full of paradoxes. Just when patterns appear, reality flips the chart. Today’s divergence between the U.S. Dollar Index (DXY) and USD/INR is exactly that kind of moment — curious, unusual, and loaded with clues for what may come next.

The rupee has slipped to around Rs 88.45 even as the DXY has eased to 96–97, nearly 15 points below its 2025 peak. Meanwhile, emerging market peers like the Mexican peso and Brazilian real are not only holding steady but appreciating. That leaves India standing out as the outlier — and that’s where the story gets interesting.

Why the divergence?

There are three main reasons behind this unusual divergence between DXY and USD/INR:

1. RBI’s forward market unwinding

The Reserve Bank of India’s net short position in the forward dollar market has been a key factor. Under former Governor Shaktikanta Das, the RBI leaned on short forward contracts and offshore NDF interventions instead of spot reserves.
By early 2025, these short positions had swelled to nearly $89 billion, about 15% of total reserves. Since Sanjay Malhotra took charge, the RBI has been steadily unwinding them. This meant most inflows were absorbed for settlements rather than strengthening the rupee in spot markets. Natural rupee appreciation was muted, planting the seeds of today’s divergence.

2. FII outflows

Foreign institutional investors have been persistent sellers this year, with net sales amounting to $10.39 billion so far. The contrast with Asia is stark: after Trump’s tariff announcements, Japan’s Nikkei surged nearly 45–50%, Hong Kong’s Hang Seng gained about 40%, and South Korea’s Kospi climbed 45–50%.

India’s Nifty, by comparison, has managed only around 17–18%. This underperformance highlights capital reallocations away from India, adding further drag on the rupee.

3. U.S. tariffs

Washington’s double-barrel tariff move — 25% plus 25% on Indian exports — has tilted the balance further. Framed as a penalty for India’s continued Russian oil purchases, the tariffs dented export earnings, intensified FPI outflows, and rattled investor sentiment. This isn’t dollar strength — it’s rupee weakness.

History suggests such divergences don’t last long. In 2013, a similar gap opened between DXY and USD/INR; once the dust settled, the rupee clawed back nearly 10 rupees.

So, how will this divergence resolve? Will the Dollar Index regain strength, or is the rupee poised for a rebound? Or will both meet halfway? To answer, we must examine fundamentals on both sides.

The dollar’s side of the ledger

On the U.S. side, the story looks increasingly fragile. The Federal Reserve cut the federal funds rate by 25 basis points to 4.00%–4.25% — widely expected, but signalling a clear shift toward easier policy.

Policymakers also outlined a deeper easing path: two more cuts totalling 50 bps by end-2025, and another trim in 2026. That guidance alone weighs on the dollar, but the data backdrop makes the case even weaker.

Core CPI is still running at 3.1% year-over-year, above the Fed’s 2% target, but cracks are forming in the labour market. Jobless claims just saw their steepest weekly rise in over a year, pointing to stress.

The broader economy reflects the same weakness: industrial production has slowed to 0.9%, consumer confidence is losing steam, and GDP shrank –0.5% last quarter. Even bright spots like PMI and retail sales appear more like temporary resilience than structural strength.

The housing market deepens concerns — building permits, a reliable forward indicator, have slumped to pandemic-era lows, while inventories rise and builders retreat.

Moody’s now warns several U.S. states are edging toward recession. Meanwhile, the federal debt burden compounds vulnerabilities: debt equals nearly 120% of GDP, and annual interest costs of nearly $880 billion have overtaken Medicare and defence spending. With borrowing costs more than doubling since 2022, debt servicing now weighs heavily on the dollar.

The rupee’s side of the ledger

• Strong GDP momentum: India’s real GDP expanded 7.8% in Q1 FY26, with July–August data pointing to continued momentum. Among G20 peers, India stands out as the only economy sustaining strong growth for four consecutive years.

• Structural reforms: GST adjustments and improved tax administration have simplified compliance, freeing companies to focus on expansion.

• Sovereign credit upgrade: India’s sovereign rating was raised from BBB- to BBB for the first time in nearly two decades, reflecting policy stability and macroeconomic credibility.

• Trade and external balance: The merchandise trade deficit narrowed to $26.49 billion in August from $29.7 billion a year earlier. Imports fell 10.1% while exports rose 6.7%, showing resilience despite U.S. tariffs.

• Oil and import relief: Softer global demand and OPEC+ supply increases are easing India’s energy import bill, reducing external pressure.

• Currency alignment: The rupee’s REER corrected from 108 in Nov 2024 to around 100, with USD/INR touching 88.45. Much of the prior overvaluation has unwound, limiting further downside and creating room for recovery.

Together, these factors suggest the rupee is better positioned to lead the correction. Much of its weakness stems from temporary tariff shocks and FII outflows — pressures that could ease.

Which way will the divergence break?

Fundamentals point one way: the Dollar Index is unlikely to mount a strong rebound, while India’s growth, policy credibility, and external buffers create a solid base for capital inflows. This makes the divergence more of a temporary imbalance than a structural shift. With DXY staying soft, the rupee looks set to regain strength.

In the near term, USD/INR is likely to face stiff resistance at 88.50–88.75, marking a potential short-term peak. Beyond that, the broader trend over the next quarter favours gradual rupee appreciation, with the pair drifting back toward 87.00–86.50.

Strategy for importers

Hedge selectively. Cover near-term payables of 15 days to 1 month around 87.90–87.50. Avoid covering 2–3 month exposures at current levels, as pricing is less attractive and the medium-term outlook favours rupee strength.

Strategy for exporters

Cover about 70% of exposures at current levels of 88.20–88.40. Those waiting should maintain a strict stop-loss at 87.90 to guard against sudden rupee gains. This approach secures value while keeping room for additional upside if the rupee weakens further.

(The author Amit Pabari, is MD at CR Forex Advisors)

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)