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Financial markets remained focused on the developments in the euro zone ahead of a high level summit of European Union’s 27 leaders. European policymakers put together new arrangements to contain the debt crisis but shied away from more ambitious changes. European Union leaders struck a deal in the early hours to draw up a treaty by March that would bind them to strict new rules on debt and deficits. The deal lacked the support of all members, with UK refusing to back the treaty.

One of the key measures was a commitment to bring forward a new €500 billion euro zone rescue fund, the European Stability Mechanism, by a year so that it becomes operational in July. In another shift, European leaders said they would consider lending up to €200 billion to the IMF, bolstering the fund’s own resources to fight the crisis. The European Central Bank (ECB), which cut interest rates on Thursday and unveiled a range of measures designed to support the euro zone financial system, however remained opposed to the idea of supporting European government bond markets more aggressively.

In the currency market, the euro clawed back some losses against the US dollar after European Union leaders announced a new deal. The single currency dipped 0.3% on the news on Friday, and then recovered 0.2% amid a cautious improvement in sentiment. Purchases of peripheral sovereign debt from the ECB under its securities markets programme also helped the single currency. The euro ended the week 0.1% lower against the US dollar.

The pound was the best performing global currency. The sterling rose 0.5% as Britain will stay outside of the European Union budget agreement. To help bolster the flagging economy, the Bank of England policy makers kept the benchmark interest rate at a record low 0.5% on December 8, and their asset-buying target at £275 billion ($431 billion). Emerging Asian currencies weakened on signs that euro zone crisis was slowing down economic growth in the region. The South Korean won was one of the poorest performers. It lost 1.3% to reach against the greenback after the country’s central bank lowered its growth forecast for 2012, citing the impact of developments in the euro zone.

In the local inter-bank market, the Indian rupee weakened by 1.6% against the US$. Market sentiment was also negatively affected by the government’s decision to suspend the decision on foreign direct investment (FDI) in multi-brand retail. Demand for dollars from the corporate sector increased even as FIIs bought $1.56 billion of local debt and stocks.The Reserve Bank of India (RBI) intervened in the market to support the rupee by selling dollars. Over the week, rupee-dollar pair traded in wide range of 51.23-52.335.

The week ahead will see release of key US economic data. That suggests the US dollar may see sharp intra-day movements, but any major breakout from the current trend is unlikely on low market volatility expectations and a typically quiet price action into late December.

Market participants would look for surprises in US advance retail sales data, a US Federal Reserve rate decision meeting, and consumer price index inflation data. Expectations point to fairly uneventful economic data releases, and the US FOMC is exceedingly unlikely to announce any shifts in policy. That means that any unexpected results could force sharp reactions from financial markets and the US dollar. The ongoing fiscal crisis across the euro zone has pushed the euro to a multi-month low.

Yet, large speculative short positions on the euro make fresh declines in the euro-dollar pair fairly unlikely. Recent Commodity Futures Trading Commission commitment data show non-commercial futures traders near their most net-short euro since it bottomed in mid-2010. Given extremely one-sided positioning, many market participants may look to cover their short positions before the illiquid year-end trading period. Clearly, the safe-haven US dollar stands to gain on further market turmoil. Yet market participants are often at their most bearish near market bottoms. From a pure seasonality basis, the month of December tends to be positive for equities and broader risky asset classes.

A strongly negative correlation between the equities and US dollar may see the greenback weaken on the seasonal tendency.
In the local inter-bank market, rupee would gain if the seasonal pressure on the greenback holds. Markets are likely to take comfort from the efforts of the European leaders. FIIs have been heavy buyers of local sovereign government debt, attracted by the interest rate advantage.The October industrial production could have actually contracted year-on-year, while November inflation would have eased closer to 9% helped by a decline in food inflation. This is unlikely to influence RBI’s decision to hold rates steady on December 16th. However, if the central bank were to signal some softening of its stance then that would provide a boost to the equity market and also the rupee. Overall, the rupeecould continue to trade with a weakening bias and the rupee-dollar pair could trade in the range of 51.00 - 52.00.

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