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Fed rate decision, policy statement key to price action

Monetary policy actions of the major central banks across the globe drove currency market action last week.

The Bank of England and the Bank of Canada cut their policy rates by 0.25% each, putting their respective currencies, the pound and the Canadian dollar, under pressure.

The European Central bank left its policy rates unchanged, but the ECB president maintained a hawkish outlook. That helped the euro strengthen.

The US dollar, which has been a laggard due to rate cuts by the Federal Reserve since September, gained over the week.

The greenback was bolstered by the receding chances of a 0.5% cut in Fed rate on Tuesday this week and other favourable events.

Easing monetary levers and the US government’s decision to freeze rates on some subprime mortgages improved sentiment in the financial markets and equities enjoyed more gains.

Investors piled up riskier assets and carry trades were back in play, pulling down the Japanese yen.

In the local inter-bank market, the rupee appreciated against the US dollar, as capital inflows picked up.

FIIs, who were net sellers of Indian stocks and bonds last month, bought $1.2 billion worth of local assets last week. Exporters also joined in dollar selling, helping to underpin the rupee.

Dollar buying by the RBI and oil companies, limited the Indian unit’s gains. The rupee-dollar pair traded in the range of 39.375 - 39.63 last week and the rupee rose by 0.6% over the week.

On the international front, Canada and the UK became the second and third G7 nations after the US to embark on monetary easing as the financial turmoil of recent months had a negative impact on their economies.

The Bank of Canada was the first to cut rates last week. It said the unfolding subprime crisis in the US and the weak greenback were behind its decision to cut its benchmark rate to 4.25%. The Canadian dollar fell 0.7% against the US dollar over the week.

The Bank of England cut its main policy rate to 5.5% on Thursday, as financial market conditions worsened. The problems facing the BoE were highlighted last week by data showing falling house prices and slowing service-sector activity.

The pound had a poor weekly performance as market turned to price in more rate cuts the BoE in 2008. Sterling fell 1.2% over the week against the US dollar, by 1.4% against the euro and 0.8% versus the yen.

The surprise of the week was the suggestion by the president of the ECB, that the bank’s board had discussed a rate hike before deciding to leave the euro-zone rate unchanged at 4%.

Trichet was very hawkish in his statement, leading market participants to believe the ECB would leave rates on hold throughout 2008. The euro rose 0.6% over the week against the yen, and modestly against the greenback.

The central banks of both Australia and New Zealand also held their policy rates unchanged at 6.75% and 8.25%, respectively. The New Zealand dollar rose 2.1% against the greenback while the Australian dollar fell 0.5%, as the market had expected the Reserve Bank of Australia to hike its rate.

For the greenback, Friday’s non-farm payrolls data had little impact, as the 94,000 jobs added to the US economy in November was only a little higher than the 80,000 figure the market was expecting.

The US dollar, however, was firm for most of the week, boosted partly by the decision at the beginning of the week by the Gulf Co-operation Council states not to abandon their currency peg to the greenback.

This week all the attention will be on the outcome of the US Fed’s rate setting meeting on Tuesday. A 0.25% cut in the overnight funds rate is fully priced in and the Fed is unlikely to disappoint the market on that.

Therefore market participants will pay careful attention to the policy statement, which provides a cue to the Fed’s thinking on the risks to growth versus inflation.

If the Fed hints at rising concerns about inflation and sounds more optimistic on growth than in the past, then the recession fears in the US economy will recede and the greenback could see a short-term recovery.

In the local market, the rupee will continue to find support from the equity market and outlook on robust capital inflows.

However, while a Fed rate cut is beneficial for equities, it also drives up the crude oil prices and that is clearly negative for the rupee. Burgeoning trade deficit, poses the biggest threat to the rupee’s strength.

Merchandise trade data for October 2007 released last week, showed that the trade deficit so far this year is 35% larger than the last year.

Market participants would also be wary of the central bank intervention. The RBI can step-up its intervention to curb the rupee’s rise, if capital inflows pick-up sharply post the Fed rate action.

Tight rupee liquidity conditions in banking system will only facilitate the central bank’s efforts to prevent excessive rupee appreciation.

Overall, the rupee’s movement against the US dollar are likely to remain range-bound and this week the rupee-dollar pair could trade in the 39.30 - 39.60 range.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com