Rupee to appreciate on improving risk appetite, favourable market momentum

Given the lack of fundamental support, the dollar will remain range bound.

Last week, financial markets saw further improvement in risk appetite as optimism on global recovery outweighed escalating political tensions that is spreading through North Africa and the Middle East. Global equities continued their relentless northward march.

Strong investor risk appetite was underlined by 2.8% rebound for emerging market stocks following their recent underperformance.

However, there was evidence that the markets were becoming cautious of geopolitical risks as the traditional safe havens of precious metals and the Swiss franc gained ground and US Treasury bonds attracted buyers.

In the currency market, much of the week’s market action was also centered on a rise in the Swiss franc. The Swiss currency advanced, with its strong performance put down to haven demand amid Middle East unrest.

The Swiss franc’s rise also reflected comments from Swiss National Bank president Phillipp Hildebrand, who said Swiss interest rates could not remain low indefinitely given rising inflation. The franc rose 1.7% against the euro and 2.8% compared to the US dollar.

Sterling also advanced last week, hitting a five-month high on a trade-weighted basis as speculation mounted that Bank of England (BoE) would raise interest rates in the coming months. Expectations that the BoE would abandon its ultra-loose monetary policy stance heightened on Tuesday as figures showed UK consumer price inflation rose to 4% in January—-double the central bank’s target rate.

This prompted BoE governor Mervyn King to write a letter to the UK government to explain the rise. Many market participants took the note as an endorsement of the three 0.25% interest rate hikes that are priced into the market.

King denied he had given a go ahead to rate hikes on Wednesday, saying he never pre-announced a decision on interest rates and markets had got ahead of themselves. But the rally halted only temporarily. The pound continued to climb on Friday as UK retail sales beat forecast and as speculation mounted that a growing number of members of the Bank’s nine-strong monetary policy committee viewed a strong currency as a weapon that could stem inflationary pressure.

Sterling got a lift on rumours that the minutes of this month’s monetary policy committee meeting, due on Wednesday, would show that another member had joined Andrew Sentance and Martin Weale in voting for a rate hike. Over the week, the pound rose 1.5% against the dollar, climbed 0.8% against the euro and was up 1.3% against the yen.

The greenback fell 1.1% against the euro over the week. The euro rose sharply after Lorenzo Bini Smaghi, a member of the European Central Bank’s executive board, said the ECB was ready to raise interest rates as needed to counter inflationary pressures. The single currency was also aided by news that the ECB had been buying Portuguese government bonds after a fresh upturn in bond yields.

In the local market, the rupee appreciated by over 1% against the dollar helped by a rally in the stock market and the overall weakness in the greenback in the overseas market. Rupee was also helped as FIIs turned net buyers. Over the week, the rupee-dollar pair traded in the range of 45.1195-45.60.

Last week was not a favourable one for the dollar. In that performance, we see one of the primary reasons for the greenback to not establish a true and lasting recovery: the absence of support from a critical fundamental
driver.

Three prominent drivers — threat of a sharp drop in risk appetite, inevitable switch to a hawkish interest rate regime and relative outperformance in economic activity—-can reasonably be expected to provide enough leverage for the greenback to have a rally.

In the near term, underlying investor sentiment may carry the greatest risk of volatility for the dollar. But it is interest rate speculation that has the better chance at making perceptible progress as the year progresses.

There is little doubt that the Federal Reserve will keep the rate near zero until the end of the year or perhaps into the first quarter of 2012. However, rate hike expectations would build up post June when the second round of $600 billion quantitative easing programme, the Fed is pursuing, will end.

Relative growth expectations are always in the background as a driver. On that front, we have plenty of event risk in the week ahead. The February consumer confidence survey from the Conference Board will be particular interesting for its details on spending plans and the assessment of growth and employment trends.

The durable goods figures and Chicago Fed’s national activity index for January will provide a timely read on the positive contributors to growth while the housing statistics (price, new and existing home sales) could highlight a key asset market.

Over the coming week, there is nothing to project meaningful progress in the currency markets towards a sustainable pattern. The dollar could continue to trade in range bound manner until speculation decides to alter course through one of the three themes.

In the local market, the momentum appears to be favourable for the rupee as stock markets may have found a bottom for the time being and as portfolio money is returning back into Asian market.

However, any significant movement in the rupee-dollar pair also depends on the dollar’s broader movements. With greenback looking on a weaker ground, rupee could continue to see some support. Over the week, the rupee-dollar pair is likely to trade in the range of 44.80 - 45.50.

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