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Central banks’ statements and their anticipated policy actions act as a beacon for market action. Three of world’s key central banks - US Federal Reserve, European Central Bank and the Bank of England - held their monetary policy meetings last week.

The week thus promised some major movements across financial asset classes, depending on what these central banks decided to do and say. And indeed last week the US dollar appreciated sharply against its major currency peers to recover the ground it has lost over the first half of this year. That in turn cooled commodity prices further, especially crude oil, which fell by another 8%.

The trigger of this dollar surge was the ECB president Jean-Claude Trichet’s warning that growth in the Euro zone could weaken markedly over the coming months. With an eye on inflation, the ECB held the policy rates steady at 4.25%. However, the concerns raised on the future growth prospects confirmed the fears of recessionary conditions in the Euro zone.

Following the recent weakness in the activity data and business confidence, market participants had already pared down their expectations of any monetary tightening in the region. Comments from the ECB president brought to the fore the need for cutting rates in the near future. As a result, the euro suffered its biggest daily decline against the greenback in eight years on Friday, the day after the ECB announced its decision on rates. Over the week, the currency lost 3.6% of its value against the US dollar to finish the week at a five-month low. It underperformed its other major currency peers also.

Similarly, gloomy economic outlook in the UK and Japan saw their currencies also falling rapidly. Last week, some more poor economic data added to the evidence that the UK is headed for a recession. The greenback hit a 21-month high against the pound during the week. The Japanese yen also slumped to a 7-month low against it.

Otherwise, the US dollar showed limited reaction to the Fed’s decision on Tuesday to keep its overnight lending rate on hold at 2%. The federal fund futures market has scaled down the probability of a rate hike by the Fed this year.

The greenback also advanced elsewhere, reflecting the positive shift in sentiment towards the currency. It rose by 3.1% against the Swiss franc, 3.7% against the Canadian dollar and 3.1% against the New Zealand dollar in the week. The Australian dollar was the worst hit, however, after the Reserve Bank of Australia opened the way for interest rate cuts. The central bank left interest rates at a 12-year high of 7.25%, but indicated that slowing demand meant rates could be cut in the near future. The Aussie, also hit by falling commodity prices, tumbled 4.4% against the greenback over the week.

The Indian rupee was perhaps the only emerging market currency which not only withstood the US dollar assault but also appreciated against it last week. That made the Indian unit the best performing currency in Asia. With oil price easing further and the BSE Sensex finishing fifth successive week with gains, market conditions were conducive for the rupee. Capital inflows in the form of FDI and dollar sales by exporters helped the rupee further.

Dollar demand from oil companies did manage to restrict its gains. The strength of the greenback in the overseas market too had some negative impact on the rupee, especially as the offshore non-deliverable forwards market traded rupee at weaker levels than the onshore market.

Over the week, the rupee-dollar pair traded in a range of 41.867-42.487. The rupee gained by 0.7% against the greenback. It also appreciated sharply against the European majors and the yen. Against the euro, the local unit gained by 4.3%, against the pound by 3.5% and 3% versus the yen.

The US dollar may continue to hold strong this week too. Market participants are beginning to recognise that proactive monetary policy loosening by the Fed and the tax rebates by the US government would help counter the recessionary conditions in the economy of that country. That places the US dollar and the economy in a favourable light, considering that other major central banks may have to cut interest rates. The data releases from the Euro zone, the UK and Japan hold special significance now, as any signs of weakness could see their currencies tumble even further.

A strong greenback, along with evidence that the OECD economies are slowing down, will help cool off oil and other commodity prices further. That will be helpful for the equity markets and currencies of oil-importing countries. And India falls under that category. Thus, as long as oil prices are moving lower, it is positive for the rupee.

This week we may see the Indian unit consolidate on its gains. FIIs are also gradually turning buyers of Indian equity and debt, which is positive from an inflow perspective. However, a surge in the US dollar like last week will undermine the rupee and restrict its gains. The RBI too will be mindful of the rupee overvaluation (in trade weighted inflation adjusted terms), if it continues to outperform the major currency peers because of its strength against the greenback. The central bank could, as a result, decide to reduce its dollar-selling in the market. Overall the rupee-dollar pair is likely to trade in the range of 41.50-42.25 this week.

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