Oil prices, RBI policy, Dollar hold key to Rupee

Financial markets remained in a risk-off mode last week as the euro zone sovereign debt crisis fears were renewed as Spain’s dismal public finances came to light. Mid-week, talk of central banks’ intervention in Europe and the US halted a five-day selling streak in global stocks and other riskier assets.

The yield on 10-year Spanish government bonds rose back above the closely watched 6% mark at which level the government’s cost of borrowing is widely considered unsustainable. It was the second time Spain’s bond yields had breached the 6% mark since the European Central Bank (ECB) launched its long-term refinancing operation last year.

The Japanese yen advanced for a second week against the euro and the US dollar after the Bank of Japan refrained from further moves to stimulate growth. The euro fell as a growing number of market participants expected that the ECB won’t restart its government-bond purchase programme. The euro erased its weekly gains against the greenback after Klaas Knot, a member of the ECB governing council, said on Friday that he did not see sufficient justification for the central bank to buy Spanish government bonds.

The US dollar, on the other hand, appreciated against 10 of its 16 most-traded peers as market participants sought safe haven of US treasuries, pushing treasury 10-year yields below 2%. Asian currencies gained last week as the US Federal Reserve signalled it will maintain a loose monetary policy.

The week also saw China widening the trading band for the yuan against the US dollar from 0.5% to 1% for the first time since 2007. China’s decision signals a drive toward a convertible currency that also saw overseas investors get bigger investment quotas this month.

The Indian rupee lost about 0.4% of its value against the US dollar as it traded in a relatively narrow range of 51.060-51.645 over the week. The rupee was undermined by the weakness in the local stock market and FII outflows. Weaker-than-expected industrial production data and sharp downward revision of the January data, worsened the growth outlook for the economy, thereby increasing the pressure on the RBI to cut rates, which in turn would reduce attractiveness of rupee-denominated assets. Some softness in the oil prices helped the rupee.

Going forward, for the greenback, we should remain focused on two aspects in particular — risk appetite trends and the outlook for monetary policy of the US Federal Reserve and other major central banks.

There are many factors for risk-aversion. The renewed euro region financial trouble is a clear leader. But we should also follow the US 1Q earnings season and the commentary of US Fed officials. Their beliefs are well-known and thereby priced in. To change the consensus on the possibility of another stimulus expansion (which is losing favour) or the timetable for the Fed’s first rate hike (now seen before 2014), we need to see someone change their position. These factors can shape or alter the market sentiment.
Monetary stimulus would be a boon in general. For the greenback, however, it is a burden.

Therefore, a shift away from balance sheet expansion by the Fed would be an encouraging factor for the US dollar. Yet, the Fed isn’t the only central bank acting to stabilise the system. The ECB, Bank of Japan and the People’s Bank of China have all boosted risk trends through their own efforts. Market participants would also look out for any stimulus from either of these banks.

In India, the market would closely follow the RBI annual monetary policy tomorrow. The RBI is widely expected to deliver its first rate cut on the back a weakening growth momentum and softening headline inflation. Of particular interest would be the RBI’s guidance on growth and inflation over the fiscal year ending March 2013 and the cues about the magnitude of rate cuts during the fiscal.

Higher oil prices combined with suppressed inflationary pressures have prompted market participants to reduce their expectations of the total extent of rate cuts. Any signal from the RBI that it can be more dovish than what the market is expecting, would provide a boost to the equities and as a result to the rupee.

Other than that, the rupee will follow the cues from the greenback’s global movements and the oil prices. Over the week, the rupee-dollar pair could trade in the range of 51.00-51.75 with some weakening bias.

The writer is a senior economist at the Royal Bank of Scotland N.V. Views expressed here are personal.