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In the currency markets last week, the US dollar pulled back from a 15-month low on a trade-weighted basis, as China’s currency policy came under the spotlight. Ahead of the visit of US President Barack Obama to Shanghai and Beijing, China gave hints that it might be preparing to let the renminbi appreciate.

Overall, financial markets experienced a volatile week as the widespread optimism among market participants that conditions would remain conducive for dollar-funded carry trade was challenged.

Speculation mounted that China was preparing to let its currency appreciate after the People’s Bank of China omitted a key phrase promising to keep the renminbi stable in its third-quarter monetary policy report on Wednesday. The Chinese central bank added that it would consider major global currencies, not just the dollar, in guiding the exchange rate of the renminbi, which has in effect been pegged to the greenback for more than a year.

The renminbi rose sharply in the futures market, with market participants moving to price in an appreciation of more than 3.5% in the Chinese currency against the dollar over the next year. This speculation helped to pull back the dollar from a 15-month low on a trade-weighted basis. Robust Chinese data helped push the dollar index — which tracks the greenback’s progress against a basket of six leading currencies — down to a low of 74.774 early on Wednesday. Data showing strong growth in Chinese industrial production and exports helped to boost investor optimism over the health of the global economy.

The resulting rise in risk appetite put pressure on the greenback, encouraging investors to use it as a funding currency in carry trades. But the dollar pulled back from its lows as investors considered the implications of a potential change in Chinese currency policy.
The prospect of a stronger renminbi has two key implications for the currency markets.

First, any slowdown in reserve accumulation and diversification into non-dollar currenciesfrom China would reduce the downward pressure on the dollar. China has accumulated foreign exchange reserves of $2,273 billion, as a result of keeping the renminbi at artificially low levels in order to support exports. To maintain the balance of leading currencies within its reserves, China has to persistently sell dollars and buy assets denominated in other major currencies especially euros — and to a lesser extent, the British pound and Japanese yen — as it accumulates the greenback.

Second, a stronger renminbi would represent a tightening in monetary conditions in China, which could potentially put downward pressure on commodity prices and boost the greenback. Over the week, the dollar fell 0.5% against the euro, 0.4% against the pound, and eased 0.2% against the yen.

The Australian dollar hit a 15-month high against the dollar after a rise in Australian employment heightened expectations that the Reserve Bank of Australia would raise interest rates. Over the week, the Australian dollar rose 1.6% against the greenback.
In the local inter-bank market, the rupee appreciated by 1% against the dollar. The
Indian unit was helped by a rally in the stock market and large inflow of portfolio investment. FIIs bought local assets worth $1.7 billion last week. The rupee-dollar pair traded in the range of 46.28- 46.75 over the week.

Looking out this week, the most pressing question for market participants is determining if and when the greenback will finally break into its next trend. While there are a few notable economic indicators scheduled for release over the coming days, there is a low probability that anyone could actually cause a meaningful change of trend.

The dollar’s primary role is as the safe haven and funding currency would stay intact. Through the coming months risk appetite will continue to define the dollar’s future. To break the negative correlation with risk appetite, the greenback will need to shed its role of the safe haven and carry trade funding currency. A shift in interest rates and/ or the fiscal health of the US can do it. Currently, the benchmark market rate — the three-month Libor — is lower than it Japanese counterpart. A major shift in capital flows into the US or an accelerated timeline for Fed rate hikes can change this.

To increase the tepid probabilities of a near-term rate hike, the market will take note of this week’s economic data. Retail sales will serve as a barometer for consumer spending (accounting for approximately three-quarters of US GDP) and the October CPI inflation numbers will reveal whether there is any merit to hawkish concerns through fears of looming inflation.

In the local market this week, price action in the rupee-dollar pair would continue to follow the equities market and the dollar strength. With a pick-up in portfolio inflows and the generally supportive sentiment for the local stock market, the rupee could find some support. The movements of the dollar in the broader currency markets would also be important and therefore any news related to the relaxation of the Chinese currency peg could bolster the dollar. The rupee-dollar pair could remain stuck within the recent range and trade within 46.00-46.75 band.

The writer is senior economist,ABN Amro Bank, and can be reached at gaurav.kapur@in.abnamro.com. Viewsare personal.