Persistent weakness in dollar could boost rupee’s gains

Financial markets were taken over by an optimistic mood last week. Last weekend’s pledges by finance ministers of the G-20 group of developed and emerging economies, to maintain policies aimed at bolstering global economic recovery, was the trigger for the upbeat market sentiment.

That, along with continued signs that the global economy was recovering, boosted risk appetite prompting investors to go in search of higher-yielding assets. Economic data releases in China and the US on Friday backed up the positive mood, and equity markets ended the week with strong gains.

In this backdrop of improved risk appetite, the US dollar put in its worst performance in four months in the first full week of post-summer trading. After trading in a relatively narrow range since the start of July, the greenback broke sharply lower, hitting a one-year trough on a trade-weighted basis and dropping to its weakest level against the euro since the start of the year.

Last week, the dollar index, which tracks its trade-weighted value against a basket of six major currencies, fell 1.9% to 76.69 — its lowest point since September 2008.

Increasing investor confidence was one of the main driving forces behind the greenback’s fall.

Safe haven demand for the US dollar was dented after last weekend’s G20 meeting of finance ministers. The dollar fell 2% against the Euro and lost 1.6% against the pound.
In recent times, rise in risk appetite among market participants has also weighed on other low-yielding currencies, such as the Japanese yen and the Swiss franc, but last week, both these currencies advanced against the US dollar.

Over the week, the greenback fell 2.5% to a seven-month low against the Yen and dropped 2.1% against the Swiss franc.

Such price action indicated that dollar weakness was not solely related to improved risk appetite. Concerns over the dollar’s reserve currency status, which were rekindled by an agency of the United Nations, also appeared to have affected the greenback. In its annual report, the UN Conference on Trade and Development (UNCTAD) urged for the creation of a new world reserve currency system using several currencies rather than just the US dollar, and called for tough controls on cross-border financial flows.

Other factors that seemed to have exacerbated the downside on the greenback include market positioning and rebalancing of reserves by central banks. Market bets against the greenback were running at relatively low levels ahead of last week’s sharp move, which indicates a rapid change in market positioning.

Moreover given that central bank dollar reserve accumulation had accelerated in August - reserve managers would have had to sell the US dollar to rebalance the currency weightings within their foreign currency reserves.

The US dollar lost ground against commodity-linked currencies, hitting one-year lows against the Australian dollar, the New Zealand dollar and the Norwegian Krone. Over the week, the greenback fell 1.5% against the Australian dollar, lost 2.6% against the New Zealand dollar, dropped 1.5% against the Norwegian krone and fell 1.1% against the Canadian dollar.

In the local inter-bank market, the rupee also appreciated by 0.8% against the greenback. Strong equity market performance, coupled with continuing portfolio inflows and US dollar’s overseas weakness helped the rupee gain ground last week. The rupee-dollar pair traded in the range of 48.285-48.765 last week.

This week promises to be another action packed one for the currency markets, with momentum clearly against the US dollar. There are however, key US economic data releases which could either push the greenback lower or could bring about some correction and consolidation.

Notable data releases include the historically market-moving advance retail sales, consumer price index, and the Treasury international capital system (TICS) reports.
Consensus market forecasts see a noteworthy pickup in domestic retail sales - a sign of improving consumer demand.

But the expected surge is mostly a function of the highly-publicised “cash for clunkers” programme that strongly boosted auto sales. Market participants would instead watch for surprises out of the ‘ex autos and gasoline’ figure - predicted to gain a paltry 0.1% on the month. If numbers prove better than expected, equities would rally and the US dollar may decline.

Consumer price index numbers are less likely to force any major currency market volatility, but any large deviations from consensus expectations could generate some price action. Most market action can be expected to come on the subsequent TICS data.

Massive US fiscal deficits could harm the US dollar, as the government floods markets with debt securities to fund that deficit. Recent data, however, shows that foreign demand for US Treasury bonds remains robust, and the dollar has thus far averted disaster because of that.

It remains important therefore, to watch for continued demand for US Treasuries, and any disappointments could further fuel dollar losses. In the local market, the greenback’s weakness in the overseas market would continue to help the rupee gain ground.

However, with equity markets having made a 18-month high last week and with market valuations looking stretched, some stock market correction could put rupee under pressure and arrest its gains.

Even the RBI would look to temper rupee’s gains, noting that exports have now contracted for 11 successive months and a stronger rupee would certainly not help in boosting external demand. The pair could trade in the range of 47.80- 48.60 this week.
(The author is senior economist, ABN Amro Bank. Views expressed herein are personal.
E-mail: gaurav.kapur@in.abnamro.com )