Risk aversion, trade deficit could drag rupee lower

Global risk sentiment remains fragile.Doubts grew over the strength of the US economic recovery last week. A string of disappointing US data releases culminated in Friday’s news that non-farm payrolls had fallen by 263,000 in September —- far more than the 175,000 expected by the consensus market estimate. Meanwhile, the unemployment rate hit 9.8% —- its highest level since 1983. Weakness in the labour market remains the vital missing component of the US economy’s recovery.

The other key data release, the US Institute for Supply Management’s September report, also cast doubts over the recent rebound in manufacturing activity. Even data on manufacturing activity as measured by purchasing managers’ surveys were also disappointing in the US, UK, Europe and Japan, failing to show steady, month-on-month progress.

Thus, weak economic data from the developed economies halted the liquidity-fuelled rally seen in riskier asset classes over recent weeks. Market sentiment was adversely affected, reducing risk appetite, and that undermined the equity market.

Heightened risk aversion in the currency markets offered support for the Japanese yen, and the US dollar. Market participants favoured the yen as their safe haven of choice. Comments by the new Japanese finance minister, Hirohisa Fujii, sent the yen to an eight-month high on Monday.

Fujii said the recent dollar-yen moves have not been “abnormal” and that “foreign exchange dumping” to defend his country’s exporters would be wrong. The minister had previously commented on the benefits to consumers of a strong yen, raising speculation that the new government would not intervene in the market. Later, a clarification from Fujii, in which he denied he was in favour of a strong yen, did cool appetite for the currency. Over the week, the yen was down 0.2% against the US dollar, up 0.61% versus the euro and was marginally weaker against the pound.

The US dollar finished the week higher against the euro and other key counterparts, but a sharply disappointing non-farm payrolls report nearly derailed the nascent greenback recovery through Friday’s close. The trade-weighted US Dollar Index had hit fresh monthly highs near 77.50 just ahead of the release.

The euro, after initial losses following the payroll report, recovered 0.6% on Friday to stand 0.8% lower on the week.  Elsewhere, possible intervention in the foreign exchange market by Swiss authorities on Wednesday drove the Swiss franc sharply lower against the euro on the day. But it had recovered much of its lost ground by Friday against the euro. Among other majors, although the Australian dollar remained flat on the week, it surged 1.5% on Wednesday. This followed robust retail sales data, which added to evidence that the country’s recovery was gaining pace.

The local interbank market saw low trading volumes due to a holiday-shortened week. The rupee-dollar pair traded in the range of 47.70 - 48.105 in the two trading sessions last week. The Indian unit finished the week stronger by 0.5% against the greenback, helped by another week of gains for the equities market. FIIs remained net buyers of local stocks and bonds and pumped in $843.7 million into the Indian market.

This week, market participants would continue to track any shift in risk sentiment, but a relatively less important US economic data released leaves limited scope for major daily moves. The notable exception is Monday’s US ISM Non-Manufacturing report, which will shed more light on the state of the domestic services industry. According to 2008 estimates, the services industry accounts for nearly 80% of the US GDP. Any noteworthy surprise in the highly-anticipated report could force major moves in the US dollar and broader financial markets.

Strong correlations between the US dollar and risky asset classes leave the greenback to gain the most from the recent upheaval in the equity markets. It will, therefore, be critical to watch for any sign that the recent equity market tumble is the start of a larger decline. Any significant decline in equities on the back of growing risk aversion would benefit the US dollar.

Other than the ISM report, market participants would keep a lookout for a number of important global central bank interest rate decisions this week. Uncertainty surrounding Australian, British and European central bank announcements may make for significant price action across key currency pairs.

The price action in the local market would continue to take cues from the equity market action and the movement of the US dollar overseas. Recent gains in the local stock market may cap further gains, especially in the backdrop of global risk aversion. That could put some pressure on the rupee.

From a fundamental standpoint, too, the rupee remains vulnerable to the current account deficit pressures. The June quarter balance-of-payments data released last week and the August trade deficit data point towards the fact that current account deficit would continue to challenge any appreciation pressures on the rupee. The current account deficit for the first quarter of the current fiscal stood at $5.8 billion, despite a sharp decline in imports, especially oil imports, as invisible receipts such as software exports remained slack.

And if we consider that the August trade deficit rose to $8.4 billion from $6 billion in July, on the back of higher non-oil imports, the overall current account deficit could continue to act as a drag on the rupee. This week, the rupee-dollar pair could trade in the range of 47.75 - 48.25.

The writer is senior economist, ABN Amro Bank. Views expressed are personal.