Rupee likely to trade with weakening bias as market momentum favours dollar

Speculation that Ireland would accept a fiscal aid package from the eurozone and the IMF calmed market tensions last week and that saw a subsequent recovery in financial market risk sentiment.

The news that Chinese central bank has increased the amount of deposits it requires banks to keep with it by 0.50%, did temper the risk sentiment again. However, risk appetite improved when market participants turned to more hopeful signs, such as corporate earnings in the US.

In the currency markets, the euro recovered from a six-week low against the US dollar last week on hopes that Ireland would receive a rescue package from its European Union partners and the IMF. The currency benefited from optimism that a deal for Ireland would stabilise the eurozone government debt market and help prevent Ireland’s troubles affecting other countries in the region with high sovereign debt, such as Portugal and Spain.

The euro dropped to a six-week low on Tuesday against the greenback as worries over Ireland’s finances intensified. The single currency however regained most of the lost ground to finish just 0.1% lower over the week. The euro climbed 1.1% against the yen over the week and climbed 0.9% against the pound.

The US dollar endured sharp swings last week. The greenback rallied strongly at the start of the week as US Treasury yields rose sharply, sparking speculation that better-than-expected US economic data would result in the US Federal Reserve not following through with its plans to expand its quantitative easing (QE) programme. Data released on Wednesday showing that core US consumer price inflation measured on an annual basis fell to its lowest rate on record in October put a halt to that speculation, sending the US dollar lower.

The greenback lost more ground on Friday as Fed chairman, Ben Bernanke, defended its decision to embark on further QE. Bernanke said further action was justified, that a vigorous US economy was essential to the global recovery and that currency intervention from current account surplus emerging markets countries was inhibiting the necessary adjustment of global imbalances.

The Fed’s decision to embark on a further $600 billion of asset purchases has been criticised, both within and outside the US, for its potential to create inflationary pressure and debase the dollar. Over the week, the US dollar rose 1.2% against the yen, rose 0.9% against the pound and was 1.1% against the Swiss franc.

In the local market, rupee’s slide against the greenback intensified. Sliding stock market, US dollar’s continuing recovery overseas and outflow of FII funds pushed the Indian unit sharply lower. Over the week, the rupee depreciated by over 1% against the US dollar to an eight-week low, as the stock market continued its slide and greenback gained against other Asian currencies. The rupee-dollar pair traded in the range of 44.90 - 45.57 over the week.

A week of broader market consolidation left the US dollar roughly unchanged from last week’s close, but the greenback’s impressive turn from significant lows is a sign that it could recover further in the weeks ahead.

Increasing volatility in the equity markets and other financial market risk barometers warn that market sentiment remains especially fragile, and any increase in tensions around the eurozone could easily force further US dollar strength.

Second-rung US economic data may make event-driven volatility unlikely in the days ahead, but market participants would keep an eye out for especially surprising results from a densely packed string of economic releases through Tuesday and Wednesday.

Such events include existing home sales data, monthly changes in durable goods orders, personal income and spending releases, new and existing home sales purchases, and the minutes from the most recent US Federal Open Market Committee meeting (FOMC).

Minutes of the FOMC have the greatest potential to move markets, as they will clarify the Fed’s thinking behind its decision to pursue the controversial quantitative easing measures by a further $600 billion announced in its November meeting. Though the Fed’s decision was almost unanimous, market participants may pay especially close attention to dissenting views from within the central bank, as several Fed officials have already spoken against such efforts.

The other events certainly have the potential to shift the financial market sentiment, but it may take especially above or below-consensus forecast results for these second-tier data releases to elicit reactions from the US Dollar. Given the recent fragility in financial market risk sentiment, risks remain to the downside on any key disappointments in consumer and housing-centric economic data.

The US Dollar’s rally in recent weeks leaves market momentum firmly in the greenback’s favour. The dollar may have established a fairly significant low against the euro and other key currencies in the days following the Fed’s announcement of the second round of QE. The recent CFTC (Commodity Futures Trading Commission) Commitment of Traders data shows that many speculators have rushed to cover short dollar positions amidst a general correction across financial markets. Yet speculators remain fairly net-short, and a further contraction of these short positions could fuel further US dollar strength.

In the local inter-bank market, rupee may continue to trade with a weakening bias, especially in the back drop of US dollar regaining traction and risk sentiment remaining on the weaker side.

Moreover, if the stock market slide continues, possibility of which is reasonably high, downward pressure on the rupee would increase. The rupee-dollar pair is likely to trade in the range of 45.20-45.75 this week.

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