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The US Federal Reserve (Fed) took financial markets by surprise last week when it announced that it will adopt a “quantitative easing” approach to monetary policy.

The Fed’s announced on Wednesday that it was going to buy $300 billion of long-term US treasuries over the next six months as a part of its efforts to expand its balance sheet and support the flagging US economy.

This was far more an aggressive move than what the market was expecting. Most market participants had expected the Fed to wait and assess the impact of previously announced measures aimed at easing credit conditions, prompting some to wonder whether the economic situation had become worse than feared.

Following the Fed’s decision to put more liquidity into the market, the fears of deflation subsided and were replaced with widespread inflation worries. In terms of market action, commodities, government bonds and the US dollar saw heightened trading activity.

The US dollar put in its worst performance in almost 25 years last week following the Fed’s decision. The greenback suffered as the expansion of the Fed’s balance sheet would increase the supply of the greenbacks and also reduce its appeal as a safe haven during the current turmoil.

The reaction to the Fed’s announcement highlighted the fact that the market does not like the currencies of central banks that print money. The news also fuelled the view that the Fed’s policy of quantitative easing could create an inflation problem in the US over the long term.

The greenback tumbled 5.1% to a two-month low against the euro over the week, fell 3.3% against the pound, dropped 4.9% against the Swiss franc and lost 2.1% against the Japanese yen. The dollar index, which tracks its value against a basket of currencies, fell 4% over the week, its worst performance since 1985.

The single currency’s surge did little to soothe mounting concerns about the Eurozone’s economic and political outlook. On Friday, the euro lost ground after figures showed that the pace of contraction in the Eurozone industrial production deepened in January.

The euro rose 1.8% against the pound over the week, however, as figures showing the UK unemployment rising at its fastest rate since 1971 weighed on the pound.
Currencies of commodity producers advanced as raw material prices rallied in the wake of the Fed’s decision to buy treasuries. Over the week against the US dollar, the Australian dollar rose 4.2% and the New Zealand dollar climbed 5.8%.

The Norwegian krone was the strongest-performing currency over the week, rising 7% against the US dollar and climbing 1.7% against the euro. Market participants and investors were attracted to the currency by its strong structural fundamentals, especially those related to public finances, sound macro-economic policies, relatively strong domestic banking sector, higher yields and no need for quantitative easing.

In the local inter-bank market, rupee too benefited from the US dollar’s weak performance overseas. The Indian unit, which rose by 1.6% against the greenback over the week, was also helped by a supportive equities market performance.

However, month-end demand for dollars from importers limited the rupee’s upward move. A rise in oil prices by 11.5% also prompted the market to cover their short dollar positions.

The news of WPI inflation falling to 0.44%, the lowest since the current series started in 1994, also raised concerns that the RBI too may take more measures to ease rupee liquidity further. Last week, rupee was helped by some tightening of rupee liquidity due to advance tax outflows. During the week, the rupee-dollar pair traded in a wide range of 50.02-51.69.

Going forward, the currency market action will be dominated by the Fed’s actions in the US treasury market for sometime. However, greenback’s weakness against major currencies, especially the euro, could prove to be short-lived. Given that the Fed, Bank of England, Bank of Japan and Swiss National Bank are already following the quantitative easing policy, over the coming months, the possibility of the European Central Bank moving towards some form of quantitative easing is going to increase.

That would limit the possible short-term gains in the euro against the dollar. In the meantime, the other main factor driving price action in the market — the appetite for risk or the lack of it — would determine the movements in major currency pairs. Risk appetite would be bolstered by the Fed’s decision and could prove beneficial for risky asset classes and could keep the US dollar under pressure.

In the local market, rupee could retain some of its recent gains until there is a turnaround in the sentiment towards the US dollar. This week, some rupee liquidity tightness in the inter-bank market could continue to support the Indian unit.

Any support from the equity market, given that the risk appetite is improving, would reinforce the rupee further. However, month-end demand for dollars would act to curtail rupee’s gains. And any further gains in oil prices, too, could exert some pressure on it. This week, the pair could trade in the range of 49.75-50.50.

The author is senior economist, ABN Amro Bank. Views are personal.
gaurav.kapur@in.abnamro.com