Volatility in $ and equities could check rupee’s gains

Financial market participants marked the anniversary of Lehman Brothers’ collapse by driving equities and other risky assets to new yearly highs last week. The rally in risky assets, which has now lasted for six-months, showed little sign of fading. In the currency markets, this risk appetite, buoyed by further signs of recovery in the US economy and large amounts of liquidity in the financial system, kept the US dollar languishing near its 2009 lows. The US dollar fell to fresh one-year lows as rising risk appetite stemmed safe haven demand for the greenback. Improved investor confidence has made the carry trade attractive again.

The pressure on the greenback came from low borrowing costs in US dollars, with dollar Libor now below that for the euro, yen and Swiss franc. The benchmark, 3-month Libor rate dropped to a new record low (0.28948%) last week.

The greenback appears to have replaced the Japanese yen as the funding currency of choice in the global carry trade. Continued improvement in market sentiment encouraged investors to sell the low-yielding greenback to seek higher returns in riskier assets.

The dollar index, which tracks its trade-weighted value against a basket of six important global currencies, fell to a one year low of 76.01 on Thursday, taking its losses since the start of the month to 2.7%. The US dollar also dropped to a one-year low against the euro, falling 1% over the week, and to a 14-month trough against the Swiss franc, dropping 0.8% on the week. The dollar also suffered against other buoyant commodity-linked currencies. During the week, the Australian dollar climbed 0.5% against its US counterpart, the New Zealand dollar rose 0.5% and the Canadian dollar gained 0.7%.

The greenback also fell to a seven-month low against the yen on Wednesday after comments from Hirohisa Fujii, Japan’s incoming finance minister, calmed fears that Japanese government would intervene to stem the currency’s appreciation. Fujii said the new government, which took power on Wednesday after a landslide victory by the Democratic party in elections last month, opposed intervention in the currency markets unless price swings became excessive, adding that recent yen moves were not a concern.

Worries that Japan would move to help its exporters and step in to weaken the yen have heightened in recent weeks, as the Japanese currency has risen rapidly. Comments from Fujii suggested that the new government was less interventionist than its predecessor. The yen, however, later gave back its gains, due to caution ahead of Japanese holidays this week. Over the week, the yen eased 0.7% against the greenback.

The pound also suffered, dropping 2.3% against the US dollar over the week and falling 3.3% to a four-month low against the euro, as expectations grew that the Bank of England (BoE) would hold interest rates at a record low for a long time. The prospect for further quantitative easing measures in the UK were also heightened after Mervyn King, the BoE governor, told the UK Parliament that he was considering lowering the interest rate paid on commercial deposits held by the banks with BoE to inject liquidity into the financial system.

In the local inter-bank market, the rupee too had a good run against the US dollar. The Indian unit appreciated by about 0.7% against the greenback last week, hitting a one-month high in the process. Besides a weaker dollar overseas, rupee was helped by the rally in the stock market and large inflow of portfolio funds. The BSE Sensex went up 2.9% and the FIIs bought local stocks and bonds worth $1.3 billion over the week. The rupee-dollar pair traded in the range of 47.94-48.80 during the week.

This week, market participants would continue to look for cues on the state of risk environment. The improvement in risk appetite so far this year has been founded on growing indications of economic recovery, particularly in the US, and the large amounts of liquidity provided by policymakers.  Investors therefore would be closely watching for any shift in stance by central banks. In this backdrop, the meeting of the US Federal Reserve’s rate-setting committee, FOMC, will attract a lot of attention for any commentary that can throw some light on the time table for a rate hike.

The economic data calendar is light this week but US durable goods orders and housing data (existing sales, new home sales) can supply short-term volatility. Data aside, the US/China trade spat hints at a growing concern with protectionism, which may come under scrutiny at the September 24/25 G-20 meeting.

The rupee would continue to trade with a strengthening bias this week. However, given that equity market movements drive the price action in the rupee-dollar pair, market participants would look for cues from the stock market. With upside in equities now looking increasingly in sight, rupee could face some resistance on its way up in case of a market correction.

And with the economy entering into a busier period, non-oil imports could also pickup, especially of commodities. Moreover with oil prices under upward pressure, the trade deficit may not shrink anymore. That too could act to slow down any appreciation pressure on the rupee. Some consolidation may also be possible in the US dollar overseas. Over the week, the rupee-dollar pair could trade in the range of 47.75-48.50.