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Financial markets for most part last week were building up a risk appetite on speculation that the worst of the Euro zone sovereign crisis may be passing.Investors had reduced the interest costs they were imposing on Italy and Spain to borrow. The successful auctions eased fears that the continent’s fiscal funding difficulties would hobble global growth.

Mario Draghi, president of the European Central Bank (ECB), said on January 12 that the institution had averted a serious credit shortage and economy is stabilising with data showing rebounds in German exports and French business confidence.

These hopes were dashed by a blanket downgrade of S&P’s sovereign ratings of Euro-zone economies last Friday. France and Austria lost their top credit ratings in a string of downgrades that left Germany with the Euro area’s only stable AAA grade.

S&P warned that crisis-fighting efforts are still falling short. The highest profile cuts came from France and Austria which lost their AAA-status by one notch to AA+ and were left with a negative outlook, which suggests there is a 50% chance of further downgrade in the coming two years. The French and Austrian downgrades could well weaken the region’s €440-billion rescue programme.

In the global currency markets, € moved sharply lower against other major currencies last Friday, ahead of S&P downgrades, virtually confirming earlier reports that France was about to lose its AAA rating. € had lost ground earlier that day after a fresh auction of Italian government bonds received poor response from investors, increasing the bearish sentiment on the single currency. Late in New York trading, however, € extended its losses after S&P confirmed it had downgraded a number of Euro-zone countries. € gave up Thursday’s gains to fall to a 16-month low against $. Over the week, € fell about 1% against £, 0.3% each against ¥ and $.

The decision on Thursday by the ECB to hold interest rates steady at 1% was also not seen as supportive for €, amid expectations that rates would be cut in the near future to help exports.

Asian currencies gained for a second week on signs European efforts to contain the debt crisis are working, boosting sentiment for riskier emerging-market assets. In India’s inter-bank market, Rupee appreciated by 2.3% over the week against $ on the back of a sharp pick-up in foreign portfolio inflows helped by an improvement in the risk appetite. FIIs bought $1.7 billion worth of local stocks and bonds over the week. The Rupee-$ pair traded in the range of 51.305-52.87.

This week will see the full impact of the S&P serial downgrade on the markets. Rating cuts to Italy, Spain and Portugal can have a more systemic impact. Portugal debt is now ‘junk’ status and Spain’s cut further exposes the lack of transparency in the region’s exposure. Yet, as S&P and Fitch have both stated, Italy is most highly exposed to further market deterioration, and presents the greatest threat to intensifying the Euro-zone financial crisis.

$ would benefit significantly from a mass exodus of capital away from €. To drive $ higher, a slide in risk appetite and deterioration in normal market function would represent the ideal conditions. We may finally see a passive appeal for $ turn into a genuine trend moving in the week ahead, if the Euro-zone’s fresh sovereign debt troubles infect underlying risk appetite trends.
In India, Rupee is likely to lose the ground it gained last week and the Rupee-$ pair can slip back well above the 52 mark. A squeeze in the global risk appetite would affect the flow of portfolio capital in India and a severe squeeze may even intensify capital outflows.

Away from the Euro-zone crisis, market participants will also focus on the oil market, following recent sharp moves. Brent crude topped $114 a barrel last week on worries about supply disruption as the US and the European Union continue to pressure Iran about its nuclear ambitions, and as Nigeria tries to avert a strike in its oilfields. Increase in crude oil prices and volatility in capital inflows can push rupee lower. This week, Rupee will likelytrade with a depreciation bias in the range of 51.50-53.00.

The writer is a senior economist at the Royal Bank of Scotland NV Views expressed here are personal.

gaurav.kapur@rbs.com