Column

Mounting concerns about sovereign debt, both in the euro zone and the US, nerves over European bank “stress tests” and fresh signs of weakness in the US economy drove market participants for safe havens last week and spurred demand for gold, US and German government bonds and the Swiss franc.

Italy and Spain were increasingly sucked into the euro zone’s debt crisis. Italy was at the centre of euro zone debt market turmoil as the yield on its 10-year bonds briefly rose above 6%, a level viewed as critical in terms of the country’s financial stability. The same held true across the euro zone periphery, with sovereign credit default swap spreads — which gauge the cost of insuring against a default — widening out. Signs also began to appear of strains in some “core” countries’ debt markets, most notably France.

The uncertainty spread across to the US as international rating agencies warned of the possible consequences of Washington failing to raise the federal debt ceiling. Both Moody’s and Standard & Poor’s said they could lower the “AAA” credit rating of the US. A burst of speculation that the US Federal Reserve might take further steps to support the faltering US economy ultimately proved short-lived.

In the currency market, the euro hit a four-month low against the US dollar and a record trough against the Swiss franc last week. The single currency suffered on fears that the debt problems of relatively small peripheral countries were spreading to larger economies.

This saw the yields on both Italian and Spanish government bonds surge, sending the euro down to its weakest level since mid-March against the greenback on Tuesday. The move came amid continued debate among European policymakers, with little sign of an agreement over a second rescue package for Greece.
Speculation that the European Central Bank had stepped in to buy Italian and Spanish paper helped pull the euro back from its lows. The single currency also rallied against the US dollar on talks of further quantitative easing in the US.

But the main driver of the euro’s resilience against the dollar was the rising concern over US government debt. Rating agencies placed the US on review for a possible downgrade, saying they could cut US credit ratings if no deal was reached on raising the government’s debt ceiling.The news came amid a stalemate among policymakers in Washington, who have until August 2 to agree a new deal over US government finances to prevent the possibility of a US default. Over the week, the euro fell 0.8% versus the US dollar and 1.3% against the pound. The greenback lost 0.5% against sterling on the week.

The yen and the Swiss franc were the major beneficiaries of concerns over euro zone and US government debt, with haven demand for both currencies surging.This raised concerns among Swiss and Japanese policymakers, with officials from the two countries attempting verbal intervention, warning over the strength of their currencies.

The Swiss franc hit record highs against the euro and the US dollar, rising 3.4% and 2.6% respectively over the week. The yen rose 2.7% against the euro over the week. Against the US dollar, the Japanese yen hit its highest since coordinated international intervention to cap yen strength in March with a 1.9% appreciation over the week.

In the local inter-bank market, the rupee gave up some of its gains against the US dollar over the week. Strength of the greenback overseas and rise in crude oil prices along with local stock market losses led to the rupee losing some ground. FIIs remained net buyers of local stocks and bonds, providing support to the Indian unit. Over the week, the rupee-dollar pair traded in the range of 44.345 - 44.76 and the rupee depreciated by 0.4% against the greenback.

Risks remain weighed on the downside for the US dollar in the week ahead. Market participants have begun pricing in the previously unthinkable —- a US Treasury default —- on risks that US legislators may not agree to a budget deal as the government will soon run short of cash. The US Congress and President will have to decide on raising the Federally mandated limit on US Treasury debt ahead of the August 2 solvency deadline.

The US dollar could see sharp declines in the event of a US Treasury default. The greenback would tumble on decreased confidence in its government debt. However, it could strengthen on sell-offs in financial markets on Treasury bond-linked turmoil.
The debt ceiling is clearly grabbing the major US headlines at the moment, but the biggest long-term driver of US dollar volatility will come from inflation and employment data going forward. Fed chairman Ben Bernanke sent the greenback reeling as he struck a dovish note on monetary policy and detailed the steps the Fed could take to loosen monetary policy further.

The Fed’s next steps will depend on economic data, and markets will be sensitive to surprises. A relatively light economic data calendar promises little in the way of fresh direction. Yet it will be critical to monitor data going forward. We may be entering an extended period of pronounced US dollar volatility on doubts over the US Treasury and monetary policy.

In the local market, participants will continue to follow the developments in the euro zone and the US over the debt problems. Among the local drivers of price action would be the ongoing corporate quarterly financial result announcements. Any significant underperformance by the corporate sector could impact the flow of portfolio inflows into India and negatively affect the rupee. While some weakness in corporate earnings is priced in, any negative surprises could see a sharp market reaction, which could be unfavourable for the rupee. Rising crude oil prices also do not augur well for the Indian unit.

The rupee dollar-pair can trade in the range of 44.50-45.00 this week, with some downside bias on the rupee.

The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal.