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Interest rate expectations continue to drive the price action in currency markets. Last week, the pound fell to new lows on market expectations that the Bank of England (BoE) would be forced to cut rates, even as the UK’s central bank left its policy rates unchanged.

The US dollar also remained on soft ground, following hints from the Federal Reserve chairman Ben Bernanke of a bigger-than-0.25% cut in the overnight Fed funds rate.

In contrast, the euro outperformed its currency peers yet again, as the European Central Bank (ECB) signalled that it could raise rates to counter the inflationary pressures. And the yen underperformed even as a mood of risk aversion persisted.

The pound tumbled to a record low against the euro and lost more ground against the greenback last week as the prospects for the UK’s economy worsened.

Over the week, it fell 0.7% against the dollar, dropped 0.9% against the euro and lost 0.4% against the yen. Sterling’s fall came in spite of the BoE’s decision to keep interest rates on hold at 5.5% at its policy meeting on Thursday.

However, market participants were of the view that the BoE was putting off the inevitable, as evidence mounted that consumer spending was falling in the face of stagnant house prices and a contraction in bank lending.

The euro, meanwhile, was supported by the ECB’s hawkish stance after its decision to keep rates unchanged at 4% on Thursday. Jean-Claude Trichet, the ECB president, said he was still prepared to act pre-emptively to prevent a build-up of inflationary pressures in the euro-zone. The euro rose 0.2% against the greenback on the week and gained 0.6% against the yen.

In contrast, the dollar was undermined as a speech by Bernanke prompted the market to fully price in a 0.50% cut on January 30. Bernanke said the Fed stood ready to take “substantive additional action” to support growth. These words prompted the futures market to even price in a 50% chance of a 0.75% rate cut.

The yen also lost ground, falling 0.4% against the greenback, tumbling 2.1% against the Australian dollar and losing 2.7% against the New Zealand dollar. This was in spite of weakness in global equity markets, which in the past has helped the yen by driving investors away from carry trades.

In the local market, rupee traded in a narrow range against the greenback and finished a tad stronger. As expected, the RBI intervened heavily and curbed the appreciation of the Indian unit.

Appreciation pressure was exerted by the FIIs, who were net buyers of local equities and bonds last week. Their purchases amounted to $625.3 million.

Overall, the rupee-dollar pair traded in a band 39.20-39.345 and the rupee appreciated by 0.1%. In the rupee-dollar forwards market, the premiums eased on account of softer local interest rates.

This week, all eyes will be on the crucial US data releases of retail sales and consumer and producer price inflation reports for December. Retail sales data, a proxy for consumer spending, will be a key input in the Fed’s decision on the size of its January rate cut.

A strong reading would reduce the chances of 0.50% cut. That would help the greenback, as the market has fully priced in such a cut. On the other hand, weak sales data would only strengthen the case for a bigger rate cut. Inflation data, particularly consumer price inflation which climbed to 4.3% in November, would be equally crucial.

If 0inflation prints higher, the market could change its view on the Fed rate cut. Presence of strong inflationary pressures could force the Fed to go for a 0.25% cut only. That too would be beneficial for the greenback. This week promises to a volatile week for the major currency pairs.

In the local market, the rupee will buoyed by a likely pick-up in portfolio inflows, as the country’s largest initial public offering opens this week. Of the total $3.5 billion to be raised through this IPO, only 10% is reserved for the FIIs.

However, large foreign interest in the IPO could see oversubscription and that would bring in more funds than what the total allocated amount would suggest.

Rupee would also gain if the moderation in oil prices seen last week extends into this week. On the flip side, global equity market weakness could dampen the mood in the local market and that would curb the rupee bullish sentiment.

More importantly, the RBI would keep the rupee from appreciating beyond 39.20 against the greenback. A large unutilised limit for bond sales under the Market Stabilisation Scheme has strengthened the RBI’s ability to intervene in the currency market.

It can mop-up a large part of the rupee liquidity injected into the banking system from its market intervention through bond sales. Therefore, the RBI can counter inflationary pressures and rupee appreciation simultaneously. Overall, this week the rupee-dollar pair could trade in a range of 39.15-39.40.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com