Column

The dominance of the US dollar in recent months, attributed to its safe haven status and the world’s most liquid currency in the time of risk aversion, was challenged last week.

The fate of US carmakers played a pivotal role in driving market action. An initial optimism about a $14-billion bailout package of the ailing industry turned to gloom as the US Senate slammed the brakes on a planned rescue package. Worries about the potential impact of a collapse of the ‘Big Three’ carmakers on the US economy unsettled global equity markets and the greenback, and heightened risk aversion among investors.

Some of the pessimism from the package’s failure was cleared by the release of better-than-expected US retail sales and consumer sentiment data. However, these figures followed a string of grim US economic data - including news that initial jobless claims had reached a 26-year high - which had a noticeable impact on the currency markets as the greenback’s recent bout of safe-haven strength came to a halt. And, even as equity markets sank on Friday, the greenback failed to recover against high-yielding currencies, suggesting that the recent correlation between risk aversion and US dollar strength had been weakened by the US-specific risks of the carmakers’ collapse.

Among the other major currencies, the UK pound plunged towards parity with the euro, as the rapid deterioration in economic activity prompted talk that the UK could face a currency crisis. The pound fell 1.2% against the euro to touch a new all-time low on Friday, taking its decline over the week to 3.6%. Sterling’s trade weighted exchange rate index also hit a historic low, sinking to 78.8, its weakest level since records began in 1981. An onslaught of bleak economic data exposed the depth and severity of the UK recession and savaged confidence in the pound.

The euro outperformed its other two major currency counterparts too. The single currency gained 3% against the Japanese yen and 5% against the greenback over the week, boosted by hawkish comments from European Central Bank policymakers that suggested rates won’t be cut in January.

Price action on Friday also saw the Japanese currency rising to a 13-year low against the US dollar. The greenback later steadied, and finished the week down 1.9%. With the dollar-yen pair falling below the psychologically significant level of Y90, speculation that the Bank of Japan could be forced to intervene to slow the yen’s rapid appreciation intensified. The Japanese currency has appreciated by 17% against the greenback since August, undermining the competitiveness of Japanese exporters. This week’s Tankan business survey is expected to be exceptionally grim, which would raise pressure on the government to prop up the economy.

In the local currency market, the rupee also outperformed the greenback. The Indian unit appreciated by 2.3% against the US dollar, helped by a rally in the equity market, FII inflows and generally positive market sentiment on the back of the economic stimulus package. The US dollar’s weakness also provided upward push to the rupee, mainly through the selling of the greenback against most of the actively-traded Asian currencies in the offshore non-deliverable forwards market. Market participants ignored the worst industrial production performance in 15 years as such an event was anticipated to a large extent. More worryingly, some media reports suggested that exports in November shrank by 10% year-on-year, after registering 12% decline in October. Overall, the rupee-dollar pair traded in the range of 48.30-49.59 over the week.

This week, the focus will be on the outcome of the meeting of the US Federal Reserve committee which decides on interest rates. A 0.75% cut in the overnight Fed Funds rate to 0.25% is fully priced in by the market. In fact, the effective Fed Funds rate has been maintained close to that level since October now. That has prompted speculation that the US Fed is going to employ a quantitative easing approach to monetary policy, as the Fed Funds rate approaches zero. Market participants will therefore look for indications by the Fed that it could use such unconventional measures to prop up the US economy and kickstart the credit markets.

The US dollar’s reversal last week has raised another important question - is the greenback losing its safe-haven status? Initially, the seizure of the financial markets beginning in October sparked a sense of panic and sent investors on the hunt for safety in the form of liquid, stable and essentially risk-free US treasuries. However, this extreme sentiment has clearly tempered, though caution is still holding firmly. A sense of stability has given investors time to reassess where their funds would be safest. Demand for treasuries is still at record high as is seen in the negative yield in short-term US Treasury bills recently.

On the other hand, the outlook for growth in the US is particularly ominous along with the need for government bailouts from large industries. The market will therefore wait and watch whether the US Treasury will fulfil the White House’s proposal for a temporary bridge loan to the carmakers until a better solution can be found. This week, therefore, is very crucial for the greenback, as it could bring about another round of the US dollar weakness. In the local market, besides responding to greenback’s price movements against other currencies, market participants would also keenly await the second part of the government’s economic stimulus package.

With economic activity heading for a sharp slowdown, equity market and the rupee will be buoyed by any further contra-cyclical action by the government or the RBI. Overall, the rupee-dollar pair may trade in the range of 48.00-49.00.

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