Any sharp correction in equities or dollar could put the rupee under pressure

Global financial markets were in the grip of risk aversion. Weak US factory activity, an increase in US jobless claims and a downgrade of the euro-zone growth outlook weakened investors’ risk appetite. Concerns of major global economies coming to a halt in the second half of the year grew. 

In the currency markets, the euro suffered the most from falling risk appetite, dropping 0.4% to a five-week low against the US dollar. Safe-haven currencies were in demand as weaker-than-expected data on the US economy weighed on risk appetite.

That benefited the yen and the Swiss franc in particular, as market participants bet that central banks in these countries would not intervene to arrest their strengthening currencies. Over the week, yen was 0.7% stronger against the greenback. The Swiss franc gained 1.6% against the dollar and 2% against the euro.

The yen’s rise to a 15-year high this month has sparked speculation that Japanese authorities may intervene. Although data last week showed Japan’s economy growing at a tepid 0.1% in the second quarter of 2010, market participants appeared to have dismissed threats of intervention by the Japanese central bank.

Meanwhile the Australian dollar saw a flurry of activity and volatility last week. The possibility of a hung parliament in Australia’s election weighed on the country’s currency amid a broader flight from risk in currency markets. The Australian dollar slid 1% over the course of the week against the US dollar, hitting a low on Friday. It dropped 1.9% against the yen.

The sell-off came as market participants were positioning themselves for the outcome of Friday’s elections. Opinion polls pointed to a close race between the two main parties — the incumbent Labor party and the Liberal-National party coalition.
A further worry for currency markets is that the Green party, the largest minority grouping enjoying record support in opinion polls, could come out of the election with a strong support. That would put back on the table the prospect of a return to the Resource Super Profits Tax — that was dropped after it led to the resignation of former Prime Minister Kevin Rudd.

In Asia, another currency saw hectic activity. The Malaysian ringgit hit its highest level against the US dollar since the Asian financial crisis on Thursday after Bank Negara, Malaysia’s central bank, liberalised rules on foreign exchange transactions.

In the local inter-bank market, the rupee remained gained a tad against the US dollar over the week. Downward pressure on the Indian unit persisted on the back of a continued demand for dollars by corporates and an overall sentiment of risk aversion. But with the stock market rising to a two-year high and foreign institutional investors (FIIs) remaining net buyers, the rupee coped up with the pressure. FIIs bought local bonds and stocks worth $1.2 billion. The rupee-dollar pair traded in the range of 46.50-46.89 over the week and rupee closed the week 0.2% stronger against the greenback.

Looking ahead, the most influential driver for the US dollar is investors’ risk appetite. From recent price action, it appears that the riskier asset classes may continue to see a build-up of bear trends. This week, scheduled data releases could undermine risk appetite and riskier assets even more.

One of the most key themes driving price action is the fear that the global economy will stall in the second half of the year. If that is indeed to be the case, we will surely see early signs of it in the range of GDP revisions due for Germany, the UK and the US. These revisions could disappoint.

The German reading will be particularly important as the initial reading was a record high. If the details and revisions to this data undermine expectations for the future health of the economy, a highly unstable region could be under negative focus again.
The US GDP reading itself represents a major fundamental driver for the dollar. There is speculation that the revision could pull the reading to a sub-1% level.  If that is the case, the hope for returns and yield will dissipate — making the dollar more valuable as a safe-haven. 

As market participants wait for risk trends and the US GDP data to take control of the price actions, there are a number of top-tier US economic indicators to watch out for. These include the Chicago Fed National Activity index, durable goods, existing and new home sales figures and they could be potential increase volatility.

In the local interbank market, the rupee could remain under pressure as investor risk aversion could not only drive the US dollar stronger but also pull down equities, both of which would be negative for the rupee. The rupee-dollar pair may continue to trade within a range without any significant increase in volatility. This week’s range could be 46.50-47. However, any sharp correction in the stock market or the greenback could put rupee under pressure.

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