Column

The stellar performance of global equity markets in April stoked risk appetite and turned fortunes around in the currency market. The FTSE World index rose 11.5% in April, the strongest monthly gain for global equities since January 1987, while emerging markets rallied 16.3%, their best monthly showing since December 1993. Stock markets rallied last week, too, as investors set aside warnings that the swine flu outbreak was likely to turn into a pandemic and focused instead on emerging signs of economic recovery.

Market participants moved away from safe havens and that left the US dollar and the Japanese yen weaker. Strong stock markets, along with some better-than-expected US data, led the greenback to fall 1.6% against the pound, and 0.1% against the euro. The yen, the other victim of improved risk appetite, lost 2.1% against the pound and 3.7% against the euro. The greenback rose 2% against the yen.

Swine flu fears sent investors running to low-risk currencies on Monday and Tuesday. But sentiment improved later in the week, driving investors to emerging markets and high-yield currencies. With Mexico at the epicentre of the flu outbreak, the Mexican peso was volatile. The first few cases were discovered in the country’s capital causing the currency to drop more than 5% against the US dollar on Monday. But the peso recovered somewhat and eventually stood 3.9% lower on the week.

High-yield currencies rose in the later part of the week, with the Australian dollar nearing a seven-month peak. The New Zealand dollar also gained, following the decision by the country’s central bank to cut the main interest rate by 0.50% to a record low of 2.5%. The Aussie dollar ended the week 1% higher against the US dollar and 3% stronger versus the yen. The Kiwi made a weekly advance of 1.6% against the yen, but remained fractionally lower versus the US dollar.

Market participants also sought out riskier assets in central European and Asian emerging markets. The South Korean won climbed strongly on Thursday, gaining 4.4% against the greenback, the largest daily rise in almost six months. This move came after a large capital injection into the nation’s banking system and stronger-than-expected industrial production figures. During the week, the won climbed 4.6% against the US dollar and gained 6.6% against the yen. Meanwhile, the Taiwan dollar and Indonesian rupiah rose 1.6% and 1.8%, respectively, against the greenback.

In the local market, the Indian rupee finished the week largely unchanged against the US dollar. In a holiday-shortened week, the rupee-dollar pair traded in the range of 49.82-50.56. The Indian unit fell during the first two days of the week on the back of sliding stock market and month-end demand for dollars by importers. On Wednesday, it recovered most of the lost ground as the stock market rallied and the greenback weakened globally.

This week, all focus will be on one of the most critical event of this year, the announcement of the results of the US Federal Reserve’s stress test of the financial and the banking system on May 7. Over the past week, there were media reports suggesting that at least six of the 19 largest US banks require additional capital according to preliminary results of the tests. If the stress test results paint a gloomy picture of the US banking system, they can potentially trigger another seizure in credit and capital markets. That, in turn, would mean the return of risk aversion and a US dollar rally. If on the other hand, the results show that the financial system has now largely stabilised, then risk appetite would be stoked further and the greenback could lose more ground.

The US data scheduled for release this week can supply significant volatility too. The most notable report is Friday’s non-farm payroll release. In the past few months, this indicator has lost some of its importance as market participants have attempted to price in the severely week numbers in advance. However, with a greater focus on the pace of recession, there will no doubt be a sharp reaction to any surprises.

The European Central Bank’s rate decision on Thursday could renew the euro’s decline or mark its definitive reversal. Since October, the ECB shaved 3% off its benchmark lending rate to a record low of 1.25%. Despite this aggressive pace of easing, the single currency has been able to retain its status as a relative high yielder. Market expects another 0.25% cut this week and thus the real shock would come from the use of unusual policy methods (quantitative easing). This would be taken as a sign that the European economy is essentially in the same boat as its British and US counterpart. On the other hand, a steady policy approach would be considered a sign that the ECB is confident of a recovery and the euro will gain.

In the local market, rupee-dollar pair would continue to track the strength or the weakness of the local equities market. Post the April rally, the stock market could consolidate around the current levels, taking into account the uncertainty over the outcome of the ongoing general elections. As a result, the continuation of a global equity rally might help local markets much. The other important driver for the rupee, the greenback movements overseas, could thus become more crucial in driving the pair.

Otherwise, the external fundamentals of the economy seem to improving with narrowing trade deficit and resumption of portfolio capital inflows. In March 2009, merchandise trade deficit, at $4.05 billion, was lower than what it was in March 2008 — $6.3 billion. During last week, FIIs bought $831 million worth of local stocks and bonds, taking their total net purchases in April to $1.77 billion. If the fundamentals continue to improve, it will be positive for the rupee in the medium term. This week, the rupee-dollar pair could continue to trade in the range of 49.75-50.50.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal.