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ShareIn a week where all eyes were on the US Federal Reserve's monetary policy meeting, the outcome of the event exceeded expectations of many.
The Fed surprised the markets by announcing a 0.5% cut in both the overnight fed funds rate and the discount rate on September 18. This size of monetary loosening was much more than the 0.25% cut that a majority of market had priced in.
The US central bank chose to be pre-emptive in its bid to counter the adverse impact of a housing market weakness and financial market turmoil, on the real economic activity. And, such an aggressive move signalled to market participants that the Fed could deliver more rate cuts in the coming months.
This move by the Fed sent the US dollar to historic lows against a host of currencies, particularly the euro. The greenback fell through the $1.40 level against the euro for the first time, hitting a record low of $1.412 on Friday.
Over the week, the US dollar lost 1.6% against the single currency. The greenback also lost ground elsewhere, falling 1.3% against the Swiss franc over the week, dropping 0.6% against the pound and tumbling 3.5% against the Canadian dollar. The trade-weighted dollar index, which measures its performance against a basket of other leading currencies, fell to a 15-year low.
Investors' risk appetite recovered over the week, as Bank of England joined Fed in efforts to address the credit market problems through aggressive liquidity injection operations. In this back drop, equity markets world over soared and commodities such as crude oil and gold scaled new-highs.
Locally, the BSE-Sensex rose above the 16,000 mark and gained 6.2% last week. Such exuberance in the stock market powered the rupee's ascent against the greenback.
FIIs poured in more funds into Indian assets, with their net purchases amounting to $1.28 billion last week. Some large dollar inflows from other sources also hit the market.
As a result, despite some aggressive dollar buying by the RBI, the rupee rose to a nine-year high against the US dollar, breaching the level of 40 on its way up.
The rupee appreciated by 1.5% versus the greenback over the week, after trading in the range of 39.845-40.62. The Indian rupee was among the best performing Asian currencies last week, besides the Malaysian ringgit and the Phillipine peso.
This week, the action in the rupee-dollar pair would be driven by two sets of opposing forces. Buoyancy in the equities market amidst a recovery in risk appetites and a weak US dollar overseas, would underpin the rupee's strength. But RBI intervention along with month-end demand for dollars from oil companies, would keep a lid on the local unit's gains.
A lot depends on how the RBI deals with these renewed appreciation pressures on the rupee. At the moment, the Indian central bank can afford to be aggressive in its currency market intervention.
It can draw some comfort from the fact that the headline inflation has eased to 3.32%, much within the target of 5%. Moreover, the RBI's ability to sterilise the rupee liquidity created in the process of intervention was also reinforced recently when the government, raised the limit of outstanding bonds under Market Stabilisation Scheme (MSS) to Rs 1,50,000 crore.
The central bank, however, does not have the room to be complacent on the inflation front. Supply-side pressures on inflation are quiet strong, considering that crude oil price is above $80 and a retail fuel price hike is long over-due. Even the demand conditions in the economy are fairly robust.
In fact, the announcement of sale of bonds and T-bills worth Rs 15,000 crore this week under the MSS seems to suggest that the RBI does not want to leave too much liquidity in the banking system, depress interest rates and stoke inflation.
Therefore, the RBI could choose to allow appreciation of the rupee at a modest pace, as a stronger rupee helps in thwarting inflationary pressures arising from higher prices of imported commodities. High commodity prices, especially of oil and gold, would against a one-way movement in the rupee-dollar pair. Infact, the risk of Indian unit slipping lower against the greenback is higher this week as local market participants are yet to react to these side pressures in a significant manner.
The support Indian unit is drawing from the equity market gains and FII inflows, also raise the chances of two-way movements in the rupee-dollar pair, or, to put it simply, of higher volatility.
Global capital market conditions have a significant bearing on local stock market action. With government bond yields, particularly the long-term yields in the US, rising last week in anticipation of higher inflation, the risks for another bout of risk aversion in the near-term are increasing. And, even the credit market troubles are far from over.
This week, however, appreciation pressures would help the rupee hold on to its gains and the rupee-dollar pair could trade in the range of 39.75 - 40.20.
Views expressed herein are personal. gaurav.kapur@ in.abnamro.com
