Investor risk appetite, US dollar’s strength set to drive local currency

Financial markets were tumultuous last week as commodities and equities saw a slump amid fears over bubbles and faltering global economic growth.

Disappointing US data along with ongoing efforts by China to slow down growth and RBI’s renewed efforts to control inflation at the cost of growth, raised concerns over global growth.

The extent of the correction over the week left global stocks with their biggest weekly losses for two months while commodity prices had their worst week for nearly two-and-a-half years, with Thursday’s steep decline. An upbeat US employment report released on Friday provided some relief at the end of the week. The US non-farm sector added 244,000 jobs in April, surpassing the 185,000 consensus expectation, provoking a rebound for equities.

In the currency markets, the euro tumbled from a 17-month high against the greenback last week after the president of the European Central Bank (ECB), Jean-Claude Trichet, signaled that the eurozone interest rates would not be raised next month.

The prospect that the ECB would raise interest rates in the coming months to counter inflation, while other central banks such as the US Federal Reserve and the Bank of England remain committed to their ultra-loose monetary policy stance, has led to a sharp appreciation in the euro in recent weeks.

Early in the week, the euro hit a 17-month peak against the US dollar and a 13-month high against pound. But the single currency later fell heavily after Trichet did not use the phrase “strong vigilance” to describe the ECB’s concerns over inflation. That phrase has been used in the past by the ECB to signal that it was set to raise rates at its next policy meeting.

Over the week, the euro fell 3.3% against the US dollar, lost 1.4% against the pound and dropped 4% against the yen. The sell-off in the single currency was compounded by a report that Greece was considering exiting the euro.

Meanwhile, the greenback recovered from a near three-year low after a sharp sell-off in commodities on Thursday. This affected investor confidence and prompted unwinding of carry trades funded by selling the US dollar. The dollar index rose 2.5% over the week, recovering sharply from a 33-month low that it hit on Wednesday.

The commodity prices driven Australian dollar was badly hit, down from a 29-year high against the US dollar to fall 2.5% over the week. The greenback also rose 2% against the pound and climbed 1.5% against the Swiss franc over the week. But it lost ground against the yen, falling 0.7% over the week, taking it to its lowest level since March.

The Indian rupee also lost over 1% value to the US dollar in a week where the RBI upped the ante of monetary tightening to curb inflation at the cost of growth. The Indian central bank raised rates by 0.5% and clearly signaled its intent to sacrifice growth in the short-term in order to curb inflation.

That sent the local stock market sharply lower and the global equity sell-off added to that pressure. The Bombay Stock Exchange Sensex lost 3.2% last week. Over the week the rupee-dollar pair traded in the range of 44.275-44.90.

The US dollar could see meaningful gains against the euro. To undermine the single currency, the significant impact would come through rumours about Greece quitting the euro-zone gaining traction. European policy makers will do as much as possible to prevent this from happening.

But even should this particular concern be answered, market participants are already paying close attention to the euro’s troubles. The pullback in ECB interest rate expectations, talks of an ‘adjustment programme’ for Greece and other EU peripheral member economy issues can negatively affect the euro.

Looking at the greenback’s own fundamentals, market participants would keep the focus on three concerns. Relative growth holds the least potential to help the US dollar but Fed interest rate expectations can be stoked by a round of central bank member speeches and more importantly by the April CPI numbers due on Friday.

The most influential driver is likely to be the direction of risk appetite and its influence on the US dollar’s safe haven status. Equity markets, oil and high-yielding currencies have all dropped significantly last week. That may not have been a sustained reversal in the risk sentiment, however, it’s a start.

In the local market, rupee will remain under pressure as long as the global investor risk appetite remains weak and consequently the US dollar remains strong. Market participants will, therefore, closely watch the movements in the investor risk appetite and the euro-dollar pair. The rally in riskier assets post the US employment numbers can spill over into the next week, particularly on Monday.

Any recovery in the risk appetite would negatively affect the US dollar and would be beneficial for the rupee. The sharp decline in the commodity prices last week, especially crude oil, is a favourable development for the rupee too. If oil prices consolidate at the current level, it would be helpful for the rupee. Over the week, the rupee-dollar pair can trade in the range of 44.50-45.00 with a weakening bias.

The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal