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However, only a sharp pick-up in capital inflows can push rupee on to stronger levels

The US dollar bounced back last week after slumping to new lows against the other major currencies at the start of the week.

A broad based sell-off in commodities helped the greenback recover from those historic lows.

Signs that troubles in the US financial sector following the sub-prime crisis could turn worse and even the financial sector in Europe was vulnerable, prompted investors to sell-off riskier asset classes, particularly commodities.

Equities market too had a mixed week in terms of performance and volatility rose again. At the most important event of the week, the US Federal Reserve administered another 0.75% cut in the overnight Fed funds rate on Tuesday, lower than what a majority of market participants had expected.

On Monday, the greenback plunged to new lows against the euro and dropped to a 12-year trough against the yen. The fall came after news that Bear Stearns, had been bought by rival JP Morgan Chase renewed fears over the extent of the damage caused by the credit crisis.

The US Fed responded to the growing signs of panic in the financial markets by announcing fresh liquidity injections and cutting its Fed funds interest rate to 2.25% after its policy meeting on Tuesday.

The US dollar rallied later in the week, however, as prolonged global equity decline triggered a further reduction in risk appetite, prompting speculators to book profit in commodities. Crude oil and gold prices registered particularly sharp falls.

Crude oil slid by 7.3% over the week, and closed at $101.94 per barrel. The greenback’s slide and rising speculative interest in commodities pushed up the prices of energy, food, metals and raw materials to record levels. Therefore, a correction in commodity prices pushed up the dollar.

The greenback rallied by 1.6% against the euro over the week, 1.3% stronger against the Swiss franc and 1.8% higher against the pond. The commodity-linked currencies also came under pressure against the US dollar, with the Australian dollar falling 3.8%, the Canadian dollar dropping 3.2% and the New Zealand dollar losing 2.7% on the week.

The resurgent greenback also managed a 0.6% gain against the yen over the week. However, the yen benefited elsewhere as rising risk aversion prompted investors to cut back carry trades. The yen rose 1% against the euro on the week, gained 1.2% against the pound and surged 3.3% higher against the Australian dollar.

The pound rallied against the euro on Thursday as an expectation-beating jump in UK retail sales in February weighed on expectations of a near-term cut in interest rates. The pound still eased 0.2% against the euro.

In the local inter-bank market, the rupee closed almost unchanged against the US dollar in a holiday-shortened week.

On Monday, the Indian unit slid sharply following a 950-point slide in the Sensex. It recovered over the rest of the week as banks and corporates reduced their dollar holdings. Banks, strapped for rupee liquidity following the advance tax payments, entered into sell-buy swaps. They sold dollars in the spot market and bought them back in the forwards market. That along with the widening interest rate differential between local and US rates, pushed up the forwards premiums in the rupee-dollar forwards market.

Overall the rupee-dollar pair traded in the range of 40.35-40.83 over the week. While the rupee finished the week almost unchanged against the greenback, it made registered solid gains against other major currencies, particularly the European majors.

This week, a number of second-rung data releases are due from the US economy. The important data releases will be on new and existing home sales, durable goods, consumer confidence, the final fourth quarter GDP numbers, personal income and personal spending. Since these releases are not as important for the value of the US dollar as non-farm payrolls or retail sales are market participants would have little information to go either way on the greenback. The US dollar can resume its slide, if investors move back their funds back into commodities. However, if commodity prices slide further, the greenback could gain even more.

In the local market, month-end demand for dollars from importers and the overhang of negative sentiment in the equities market would continue to put pressure on the rupee. However, if international commodity prices slide further, the sentiment towards the local unit could get a boost.

Also, with headline WPI inflation having risen close to 6% again and more importantly prices rising sharply in case of commodities priced on an import parity basis, the RBI could consider providing it some support. Inflation is well above the RBI comfort level of 5% now.

Market participants could also start pricing in some upward pressure on interest rates, particularly policy rates, noting the upwards spiral in inflation. That would be beneficial for the rupee.

As it is with the latest Fed rate cut, the interest rate differential between local and US rates has widened further, enhancing the carry advantage of holding rupee assets.

Overall, the rupee-dollar pair could trade in the range of 40.35-40.70, with rupee holding its ground against the greenback. Only a sharp pick-up in capital inflows can push the rupee on to stronger levels and the possibility of that still remains quiet low at the moment.

The author is India Economist, ABN AMRO Bank. Views expressed herein are personal.
gaurav.kapur@in.abnamro.com