Greenback momentum and policy tightening could weigh on rupee

Financial markets continued to focus on the sluggish pace of global recovery and the risks of a sovereign default in the euro zone last week. US Federal Reserve chairman Ben Bernanke struck a cautious tone in a speech as he said the US recovery seemed to be proceeding at a “moderate pace” and the labour market was seeing a loss of momentum.

More importantly, he appeared to dash hopes that the US Fed might embark on a further round of asset purchases —- or quantitative easing —- to bolster the economy. This adversely impacted the equities market. Otherwise, oil prices rallied sharply after the Organisation of petroleum Exporting Countries (Opec) failed to reach an agreement over a hike in production quotas.

In the currency markets, the euro ran into profit-taking after the European Central Bank (ECB) dropped a clear hint that it would raise interest rates next month. The single currency fell sharply from a one-month high against the US dollar last week, failing to gain traction after the ECB signaled that it would raise interest rates in July.

The euro staged a brief rally on Thursday after ECB president Jean-Claude Trichet used the words “strong vigilance” to describe the central bank’s stance towards inflation risk after its policy meeting, a phrase that has in the past signalled a rate rise at the ECB’s next meeting.

The single currency reversed its gains, as most market participants were expecting the same from the ECB and hence factored into prices by the markets. The ECB also left its inflation forecast for 2012 unrevised, prompting a scaling back of interest rate hike expectations further ahead.

The signal for a likely rate hike in July left market participants to focus on Greece’s debt problems and the continuing debate between euro zone central bankers and finance ministers about funding. While there was a natural push for market participants to follow rising yields and buy the euro, there were also reservations that higher rates could create significant weakness for the euro in the future.

The euro, which hit a one-month high ahead of the ECB meeting, lost 2% against the US dollar over the week, fell 2% against the yen and was 0.8% weaker against the pound.

Meanwhile, a warning from rating agency Moody’s over the UK’s AAA credit rating knocked confidence in the pound, as did a drop in UK industrial production. Over the week, the pound fell 1.2% to against the US dollar and lost 1.1% against the yen.

In the local market, rupee remained confined to its recent range against the greenback. The Indian unit received support in the first half of the week as the US dollar weakened against other major currencies, especially the Euro.

However, with the greenback regaining ground and with oil prices rising sharply, the rupee surrendered some of its gains. The Indian unit finished the week marginally stronger against the US dollar. Over the week, the rupee-dollar pair traded in the range of 44.575-44.825 and the Indian unit appreciated by 0.2%.
Heading into this week, the euro area’s financial stability is likely to carry the greatest potential for the US dollar. If market confidence in the euro, which is touted as the best alternative to the greenback as a reserve currency, is weakened by a member facing default, it could certainly change the market’s expectations.

A significant deterioration in the euro zone’s financial and credit conditions could also spark a global slump in risk appetite, further helping the US dollar. As for the economic data releases, the US consumer price index data will be crucial. Consensus market estimates expect a 3.4% headline figure.

In the local market, this week holds key events and data, which would influence the market momentum. The most important event of the week is the mid-quarter review of the monetary policy by the RBI on June 16. The central bank is widely expected to raise rates by 25 basis points in order to rein in inflationary expectations. The May wholesale price index based inflation data, due on June 14, could print in the range of 8.8-8.9%.

Any negative surprise on the inflation front and/or hawkish guidance from the RBI is likely to adversely affect the equities market. Market consensus has scaled down expectations of further monetary tightening by the RBI to about 0.5%-0.75% of rate hikes in the current cycle.

However, if the central bank signals more policy tightening depending on its assessment of the inflation scenario, these expectations would be tempered and affect markets negatively. Any weakness, particularly in the stock market, will in turn negatively affect the rupee.

Market participants would also closely follow RBI guidance on the growth front, especially in the light of slowing global growth, which could negatively affect the recent momentum in exports and capital inflows.

The recent gross domestic product, purchasing managers’ index surveys and the industrial production numbers released last week also point towards slowing domestic growth momentum. At this stage, the RBI is unlikely to focus on growth —- in fact, the central bank itself wants to slow down the growth momentum. However, any caution from the RBI could further weaken the market sentiment.

Given the positive market momentum for the US dollar and the likelihood of further monetary tightening by the RBI, the RBI could come under pressure this week. Over this week, the rupee-dollar pair can trade in the range of 44.75-45.25.

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