Rupee stands to gain if dollar extends losses overseas

Financial markets saw risk appetite taking another beating last week. The trigger for this slide in risk sentiment was a batch of soft US data combined with cautious comments from the US Federal Reserve painting the picture of a US economy struggling for traction and showing deflationary signs.

News that China’s rampant growth is cooling down added to the
caution. Weaker-than-expected corporate earnings number for a host of companies in the US put further pressure on investor risk appetite. In the currency markets, poor risk appetite did not help the US dollar though.

The greenback dropped to a 10-week low against the Euro last week, with the single currency breaching $1.30 mark for the first time in two months as concerns over the US economic recovery grew. Speculation that the Fed would act to ease monetary conditions further in a bid to stimulate the economy, grew.

Weak US economic data, including softer-than-expected retail sales and manufacturing activity data sent two-year US Treasury yields to record lows. This coincided with the release of the minutes of the US Fed’s June policy meeting at which it revised down its growth and inflation forecasts. The Fed said it would have to consider monetary-easing measures if the economic outlook were to worsen “appreciably”.

The outlook for the greenback was impacted by the view that the Fed could ease monetary policy again before it eventually tightened. The euro was also boosted as a successful Spanish bond auction and a well-received Greek government bills sale, eased concerns over the Euro-zone sovereign debt crisis.

The US dollar fell to its weakest level since May 2010, before recouping some of its losses to stand down 2.3% over the week. The euro also advanced against other currencies. The single currency was up 0.8% against the pound on the week and gained 1.7% against the Swiss franc.

Falling yields on US treasuries undermined the greenback’s safe-haven appeal, pushing investors looking for safety from declining asset markets towards the relative safety of the yen. This pushed the greenback down to a nine-month low against the Japanese unit, taking it down 2.2% against the currency over the week. 

The greenback fell 1.5% against the pound over the week and was down 0.7% against the Swiss franc, to a three-month trough. Putting this weak performance into perspective, the US dollar has established the most meaningful correction in its otherwise uninterrupted rally since it began in December 2009. In the local inter-bank market, the rupee weakened a tad against the greenback despite the latter’s weakness in the overseas markets.

Rising stock markets and net inflows of $1.8 billion from FIIs provided some support to the rupee. However, the demand for dollars in the banking system remained strong, thereby negating support provided by other factors. Ballooning merchandise trade deficit, with rising non-oil imports continued to keep a check on the Indian unit’s strength.  Over the week, the rupee-dollar pair traded in the range of 46.54-46.94.

The US dollar’s path is growing more difficult to interpret. Not long ago, the currency would respond to notable shifts in underlying investor sentiment, playing the role of the favoured safe-haven. In recent weeks, however, the deteriorating fundamental health of the dollar is blurring the reaction to the changes in risk appetite.

This shift can be partly attributed to the fact that investor confidence has climbed sharply and that the greenback’s primary counterpart and the source of most investors’ concern — the euro — is showing a remarkable recovery. Looking at the US dollar’s recent activity in relation to its performance so far this year; the question at hand is whether the greenback has reversed or is it merely putting in for a much-needed correction?

We are more likely to see a definitive picture of direction this week. The immediate concern is risk appetite. There are important corporate earnings statements from US firms due this week and risk-averse sentiment would amplify any negative surprises in corporate performance.

The greenback will almost certainly revert to its role as a safe-haven currency should risk sentiment deteriorate significantly. But for the US dollar to truly regain its footing, the euro has to fall out of favour once again. That may happen. On Friday, the European Union is scheduled to release the results of its stress test on the region’s largest banks.

There is already discussion about how lenient the conditional scenarios are, as well as a notable lack of truly troubled banks from the list. The results of the stress tests otherwise are likely to paint an optimistic picture.  Should the market participants focus on the negatives, the euro can plummet.

In case risk appetite improves and the euro doesn’t tumble, the greenback could see its strength continually eroded.

Fundamentals of the US dollar based on relative growth, stability and interest rate upside potential, remain weak. Ballooning deficits and no rate-hike potential for the foreseeable future could work against the greenback. 

The rupee could gain value if the slide in the US dollar extends. The rupee has remained a laggard despite the general weakness in the greenback in the overseas market, as market participants remain doubtful about a meaningful retreat in the US dollar. Therefore any further slide in the greenback would encourage market participants to go short the US dollar.

Slower pace of capital inflows with a rising trade deficit are also keeping rupee subdued.  And, with local stock market looking overvalued, a sharp increase in FII inflows looks unlikely at this stage. In this context, the first quarter corporate results due this week would remain a key driver of the stock market and thus the rupee. Stronger-than-expected results could provide support for a rally in the equities market on the back of better earnings outlook and that would help the rupee too.  Overall, the Indian unit could remain stuck in its recent range and the rupee-dollar pair could trade at 46.25-47.

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