All eyes on RBI as market volatility continues to weigh on rupee

Financial markets saw a rally in riskier assets last week built on improving corporate earnings, better US economic data and still loose monetary policy among the major developed nations. In addition, a major concern of the market, the eurozone debt crisis, went through one of its quiet periods. Market participants took a more sanguine view over the problems in the region despite reports that Greece was in discussions to restructure its debts and worries that Portugal might have to seek a bail-out from the European Financial Stability Facility, the eurozone’s rescue fund.

In the currency market, the euro hit a two-month high against the US dollar last week as fears over the eurozone debt crisis eased.

Also supporting the euro were figures showing the German economy was recovering strongly. On Friday, the January Ifo index of German business sentiment printed at its strongest level since reunification, lifted by booming German exports to Asia and stronger household spending growth. This pushed the two-year yield spread between German and US government bonds to their highest level since 2009.

Even market positioning by investors on the euro flipped from short to long, from $7.4 billion short to $788 million long, according to CFTC figures. Over the week, the euro climbed 1.8% against the greenback, its strongest level since November 23.

The euro also climbed 1.4% against the yen over the week, rose 1.3% against the Swiss franc and gained 0.9% against the pound.

Meanwhile, the sterling rose to a two-month high against the US dollar, up 0.8% over the week as forecast-beating UK consumer price inflation data raised expectations that the Bank of England would be forced to raise interest rates to rein in rising price pressures.

The greenback also lost 0.4% against the yen over the week and fell 0.5% against the Swiss franc.

The US dollar fared better against commodity-linked currencies, however, as strong Chinese growth data heightened speculation that Beijing would tighten monetary policy to prevent its economy from overheating.

Over the week, the US dollar eased 0.1% against the Australian dollar, but climbed 0.3% against the Canadian dollar and gained 1.1% against the New Zealand dollar.

In the local inter-bank market, rupee depreciated against the greenback over the week. Volatility and the weak undertone in the stock market along with high oil prices undermined the Indian unit even as the US dollar weakened overseas. Over the week, the rupee-dollar pair traded in the range of 45.30 - 45.78 and the rupee lost 0.6% against the greenback.

Looking ahead, the US dollar may have entered a trend-setting period. The potential for forming a trend is high with many potential catalysts along the way. Investor risk appetite levels would remain the foremost. Shifting investor sentiment in one direction or the other will require a significant market development.

Europe’s financial difficulties can still move the entire market. In the past weeks, we have seen some level of relief through the belief that the EU is working together to stabilise the region’s financial troubles. However, eurozone members have struggled in the past to come to key agreements and stable mechanism for dealing with debt overhang is still far away. Other issues to contemplate include the possibility that China will hike rates, Japan will see a debt crisis, Q4 corporate earnings will break the steady bearing of confidence or the US housing sector will fall to another crisis.

Among the scheduled event risks there are two key events to keep track of. The first one carries the least potential for a major drive for the currency market. The FOMC rate decision is not likely to result in any change in the stimulus programme or benchmark rate. The accompanying statement’s tone can prove critical to defining the timeframe for an eventual return to hikes (within 2011 or after the turn over the year) and more importantly, if there is to be a change in the stimulus programme. The US Federal Reserve seems intent on follow through with the $600 billion programme and its originally planned maturity date but there have been proponents on both sides that have suggested there are contingencies for changing this timing.

The most influential release for this week will be the first estimate of the fourth quarter US GDP numbers. The US economy seems on a steady path towards recovery. Market participants, policy makers and consumers will look to ensure that indeed is the case. That said this is not as easy an indicator to interpret. A positive surprise may have the side effect of encouraging a quicker removal of stimulus by the Fed. Market participants also need to establish whether a positive or negative surprise carries more weight as a gauge for comparative growth or risk appetite.

Feeding already saturated optimism will not carry as much weight as a breakdown in investor confidence. Another thing to consider is that this is a Friday release. There will not be much time to respond to the report with full market liquidity.

In the local market, the focus will be on the quarterly review of the RBI monetary policy. The bearing of the policy statement on the stock market and therefore the rupee is particularly crucial at this stage, considering strong inflationary pressures and easing growth momentum. The central bank is widely expected to raise rates by 25 bps. Any more hawkishness than expected in terms of policy stance or actual action (in terms of rate hike) could pull the stock market and the rupee lower. Globally, improvement in investor risk appetite could this time around prove negative for the rupee, as that would stoke crude oil prices and may not be too supportive of the local stock market. The rupee could therefore continue to trade with a weakening bias against the US dollar.

The rupee dollar-pair could trade in the range of 45.25 - 46.00 this week.

(The author is senior Eeconomist, Royal Bank of Scotland N V. Views expressed herein are personal. E-mail: gaurav.kapur@rbs.com )