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ShareUS dollar could continue to rally on year-end position squaring
Last week turned out to be more eventful than market participants would have bargained for.
The key events of the week forced many of them to rethink some of the themes they have been working with in the run-up to the New Year.
One of the busiest weeks in recent months saw a break in the broad trend of US dollar weakness, particularly against its major currency peers. The greenback rallied sharply over the week and climbed to its highest levels in more than three months against the euro and the Japanese yen.
This break came about as the US Federal Reserve, even after cutting the overnight Fed funds rate by 0.25%, disappointed a large section of the market.
This section was either expecting a 0.50% cut or a clear guidance by the Fed that more rate cuts are on the anvil.
The Fed policy statement, however, was relatively hawkish and reflected the risk of inflation picking up in the US economy, even as growth slows.
The greenback rally gathered more pace towards the end of week, as data showed that inflationary pressures were building in the US economy.
Producer prices rose at their fastest rate in 34 years and headline consumer price inflation jumped to a two-year high of 4.3%. Consumer spending in the US, the mainstay of the economy, remained strong as indicated by retail sales figures being at more than double the forecast value.
Strong inflationary pressures and consumer spending holding up make future rate cuts difficult to justify for the Fed.
The interest futures markets have been betting on multiple rate cuts in 2008, and as these bets reverse course, the greenback would gain further.
Last week also saw the initiation of a co-ordinated effort by the world's major central banks to alleviate the liquidity crunch in the inter-bank funds market.
These central banks, including the Fed and the European Central Bank, plan to provide liquidity support of about $60 billion to the financial system. This news had ramification for the currency market, especially for the Japanese yen.
The news of liquidity injection stoked risk appetite and that saw the yen give back its gains on Wednesday after the banks' announcement.
The yen had rallied sharply on Tuesday after the Fed made clear that it was concerned about inflationary pressures in the US economy. That had raised fears over the prospects for global growth and pushed investors into unwinding of carry trades.
The Bank of Japan's Tankan survey, released on Friday, did not help the yen's cause as it showed that Japanese business sentiment slipped to a two-year low.
Over the week the yen endured wild swings as it gyrated along investor's risk appetite, and by the end of it, the currency had fallen 0.8% against the pound and 0.1% against the higher-yielding New Zealand dollar.
In the local inter-bank market, the price action was much calmer. The rupee-dollar pair traded in a narrow range of 39.32 - 39.422 and the Indian unit appreciated marginally against the US dollar. The FIIs brought in $728 million to purchases local stocks and bonds.
The RBI, oil companiesand other importers,however, ensured that the supply matched the demand for dollars. Equity market action was also lacklustre even as the BSE-Sensex climbed a new all timehigh.
That kept the sentiment generally positive towards the rupee.
The greenback's rally against other majors and rupee appreciating a tad against it, translated into handsome gains for the rupee against all the three major currencies last week. In the rupee-dollar forwards market, premiums rose across the board as a rupee liquidity-crunch ahead of the advance tax payments saw short-term rates rise over the week.
The US dollar could continue to hold strong this week too, as year-end short dollar position unwinding takes hold. OtherwiseUS data releases due this week are relatively less important and would have limited impact on theFed's future rate decisions.
The spotlight will therefore be on the announcementof the US financial sector
results. This would keep global equities market in a cautionary mode.
Stock markets fell last week taking the view that the liquidity injection plan is modest in comparison to the scale of losses and writedowns related to the subprime problem. Equities could be hit this week again, as these losses are declared.
In the local market, the rupee could come under some pressure due to the greenback's strength. The pressure would be more intense if the local stock market also declines and FIIs' turn net sellers of Indian assets.
The possibility of that happening is quiet high. Also, rising crude oil prices do not augur well for the rupee's strength. The sentiment in the market is also likely to be a cautious. The RBI too would remain active in its market intervention.
Overall in the spot market, the rupee-dollar pair is likely to trade in a range of 39.30 - 39.60 this week. In the forwards market, premiums could remain biased upwards on account of a rupee liquidity crunch in the banking system.
The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com
