Dollar’s resurgence to weigh heavy on rupee

Volatile swings dominated financial markets last week as commodity prices suffered a second round of significant decline. Reassuring growth data out of the euro zone highlighted by a robust performance from Germany, and US inflation data, which contained no negative surprise, brought a degree of calm to a week punctuated by bursts of selling of riskier assets like equities.

In the currency markets, the euro remained under pressure last week, touching a six-week low against the US dollar as worries over Greek government debt continued. Speculation at the start of the week that Greece was considering leaving the euro zone and concerns that Athens might restructure its sovereign debt drove the single currency lower.

This heightened concern about the finances of other countries on the periphery of the euro zone. The euro also suffered, along with commodity-linked currencies, from increased investor risk aversion, which fed safe haven demand for the US dollar and the yen.

The euro fell to its lowest level since April 1 against the US dollar on Thursday. However, the single currency regained some poise on Friday as data revealed that French and German growth exceeded expectations in the first quarter. This helped stabilise the euro and heightened expectations that the European Central Bank would deliver a further rise in interest rates at its policy meeting in July. Over the week, the euro eased 0.8% against the greenback and declined 0.8% against the Japanese yen.

The single currency rose against the pound, however, gaining 0.1% over the week. Sterling suffered as poor trade data, a growth downgrade from the Bank of England and weaker-than-expected manufacturing and industrial production figures combined to raise worries about the health of the UK’s economic recovery.

In the local market, rupee weakened a tad against the greenback over the last week. The Indian unit remained under pressure throughout the week, but the downward pressure increased towards the end of the week on the back of dollar appreciation. Weak stock markets and a recovery in crude oil prices also had a negative impact on the rupee. FIIs remained net buyers of Indian stocks and bonds, but the total size of buying was relatively small. The government disinvestment programme for this fiscal was kick-started with the follow-on public offer of Power Finance Corporation, which saw lukewarm response from foreign investors.

Over the week, the rupee-dollar rate traded in the range of 44.625 - 45.0475 and rupee lost 0.2% of its value.

Economic data related event risk is limited this week, with the exception of US Federal Open Market Committee minutes due Wednesday.

The US dollar dropped rapidly following the FOMC’s decision to leave monetary policy unchanged at its recent meeting. Fed policy makers showed little willingness to pull back extraordinary monetary policy accommodation in the post-decision statement and that negatively affected the greenback. Yet, the US dollar set its short-term bottom a few days later, suggesting that markets may have seen an extreme of its bearish sentiment. The CFTC Commitment of Traders data has showed that speculators remained heavily net-short the greenback through recent months. A broad deleveraging would further force speculators to cover leveraged US dollar-short positions and that would lead to further rally in the greenback.

Whether or not the Fed shows a substantive shift in its stance on monetary policy will be a major focus for the US dollar going ahead. It will be equally critical to watch moves in broader financial market risk sentiment. The greenback carries the second-lowest short-term interest rate of the world’s major currencies. That has encouraged market participants to heavily borrow greenback as a cheap funding source for higher returns in other markets and higher-yielding currencies.

Robust demand for these carry trades — where investors borrow at cheap rates to buy higher-yielding assets— explains a great deal of the US dollar weakness. However these trades only work well when interest rate differentials are large enough to cover exchange rate volatility. Given high volatility expectations, many market participants have got out of these carry trades. Continued corrections in broader ‘risk’ could quite easily force continued US dollar strength.

In the local market, the focus would remain on the US dollar’s resurgence and recovery in the overseas market. Recent volatility in riskier asset classes, especially commodities, has made investors increasingly averse of taking on too much risk. This contraction in the risk appetite has helped the greenback gain ground. If this pullback in risk appetite continues, it would help the US dollar remain on a firm ground.

Other than the movements in the greenback, market participants would also follow the government’s disinvestment programme. Stake sales in some of the large government-owned companies and the size of the offering would see increased foreign investor interest in the form of increased portfolio inflows. That is likely to help the Indian unit and create short-term spikes in the rupee-dollar pair. However, the fact that oil prices remain elevated remains the biggest risk for the rupee. Moreover, with growth momentum slowing down globally, the recent spurt in non-oil exports would be tempered.

This week, rupee can remain under pressure on the back of favourable market momentum for the US dollar. Over the week, rupee-dollar pair can trade in the range of 44.60 - 45.10.

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