IBSPECIAL

The first quarter of FY26-27 has so far been a reminder that currency markets are rarely driven by domestic fundamentals alone. 

While India entered the quarter supported by strong economic growth, improving fiscal discipline, moderating inflation and healthy reserve buffers, global developments have quickly emerged as the dominant force shaping market sentiment and determining the direction of US dollar and Indian rupee. What began as a period of cautious optimism has gradually transformed into a quarter characterised by geopolitical uncertainty, capital outflows, higher energy prices and persistent dollar strength.

At the start of the year, financial markets remained optimistic that 2026 would gradually transition toward easier monetary conditions and improving global liquidity. Market participants expected moderating inflation would eventually allow major central banks, particularly the US Fed, to shift toward policy easing. However, these expectations faded quickly as the US economy continued demonstrating remarkable resilience. Strong labour market data, resilient consumer spending and sticky inflation forced the market to accept a different reality: interest rates may remain higher for longer. 

As expectations for rate cuts were repeatedly pushed back, US Treasury yields moved higher, with the 10-year yield approaching 4.48%, strengthening the US dollar and tightening financial conditions globally.

At the same time, geopolitical developments added another layer of complexity. Escalating tensions across West Asia created recurring waves of risk aversion across financial markets, while concerns surrounding disruptions to energy supply routes pushed crude oil prices sharply higher. Rising energy costs reignited inflation concerns globally and increased demand for traditional safe-haven assets, reinforcing the strength of the dollar. For emerging market economies, the combination of higher US yields and elevated oil prices has proved particularly challenging.

India has found itself exposed to both pressures simultaneously. As one of the world’s largest energy importers, rising crude prices immediately increased import-related dollar demand and worsened concerns surrounding external balances. 

Meanwhile, foreign investors reduced exposure toward emerging markets. Since April 2026 to until now, foreign institutional investors (FIIs) have pulled back $13.7 billion from the Indian market as global risk appetite deteriorated. FII outflows accelerated during the quarter, creating persistent demand for dollars and adding pressure on the rupee precisely when global conditions were becoming increasingly unfavourable. On 20 May, the Indian rupee hit its all-time low at 96.97.

The deterioration in external balances has also become increasingly visible through balance of payments dynamics. After recording surpluses of approximately $38.5 billion in calendar year 2023 and $16.9 billion in CY24, India’s external position weakened considerably with CY25 moving into a deficit of around $10.8 billion. Market participants have also become increasingly cautious regarding CY26 projections, recognizing that higher commodity prices, volatile capital flows and uncertain global conditions could continue influencing external balances.

The Reserve Bank of India (RBI) responded aggressively to restore stability and adopted a broader strategy that combined spot and forward market intervention with regulatory measures aimed at reducing speculative activity. Restrictions surrounding derivative positions, tighter open position rules and macroprudential measures have helped reduce disorderly market conditions and gradually restore confidence. While these actions have not reversed depreciation entirely, they have successfully prevented panic conditions from escalating further and allowed markets to stabilise.

Interestingly, despite the sharp weakness in the currency, underlying domestic fundamentals continue to remain relatively resilient. Economic growth remains robust, inflation stays manageable, fiscal consolidation remains broadly intact and India continues maintaining substantial foreign exchange reserves. 

Valuation indicators also increasingly suggest that the rupee has moved into undervalued territory, with trade-weighted REER (basket of 64 currencies) measures indicating that a significant portion of depreciation reflects external shocks and capital flow dynamics rather than deterioration in domestic fundamentals.

As Q1 FY26-27 progresses, the outlook for USD-INR remains heavily dependent on global developments rather than purely domestic factors. Oil prices, geopolitical tensions, US monetary policy expectations and foreign capital flows are likely to remain the primary drivers of market direction. While strong domestic fundamentals continue providing an important cushion against disorderly depreciation, the rupee remains exposed to shifts in global risk sentiment. The coming weeks will therefore depend not only on India’s economic resilience but also on whether global uncertainty begins easing and markets confidence gradually returns toward emerging markets.

Currently, USD-INR movement is largely being driven by headlines and geopolitical developments rather than country fundamentals. Any de-escalation in geopolitical tensions, along with government measures such as reducing taxes on foreign investors to attract foreign capital, could lead to sustained rupee appreciation, with the pair moving towards the 94.00–93.50 levels. However, if the US-Iran conflict escalates further, USD-INR could move back towards 97+ levels. Geopolitical developments, therefore, need to be monitored closely.

(The writer is Deputy CEO at Mecklai Financial Services. Views are personal)