Rupee to be guided by dollar strength and oil

The earthquake in Japan on Friday was the latest in a series of incidents that rattled financial markets over last week. Continued fighting in Libya and worries over political turmoil in West Asia heightened concerns of an oil supply shock that could damage the global economy.

In addition, Euro-zone fiscal woes resurfaced, with peripheral bond spreads moving to records on restructuring fears, following credit rating downgrades of Greece and Spain. The cost of insuring against peripheral debt default also moved higher.

Weaker-than-expected Chinese export data on Thursday raised concerns that demand for the country’s products was slipping, possibly indicating a dip in global consumption. This confluence of events combined to depress investor risk appetite and weigh on equities and commodity prices.

In the global currency market, the US dollar recovered from a four-month low against the Euro last week as fading investor risk appetite boosted haven demand for the greenback.

The US dollar started the week on the back foot, hitting a new low in its recent down slide against the Euro on Monday. Market positioning data revealed that speculators on the Chicago Mercantile Exchange held record bets against the greenback.

The US dollar, which also hit a four-month low against a basket of currencies on Monday, has been suffering because of the diverging monetary policy stance between the US Federal Reserve and other central banks, which are seen as more likely to lift interest rates to combat rising inflationary pressure.

The greenback rallied however, as investor focus shifted from interest rate differentials towards concerns over global growth, squeezing out appetite for risk. The greenback however, gave up some of its gains towards end of week on Friday.  Over the week, the US dollar rose 0.5% against the Euro, climbed 1.2% against the Pound and was 0.4% stronger against the Swiss franc.

Commodity-linked currencies also came under pressure, with the Canadian dollar easing 0.4% against the greenback over the week and the Norwegian krone losing 1.5%.

The US dollar was 0.4% weaker against the Japanese Yen over the week, however, with the Japanese currency quickly reversing initial losses on Friday in the immediate aftermath of news of the earthquake. The Yen also rose 1% against the Euro over the week and climbed 1.6% against the Pound.

The safe haven characteristics of the Yen were seen protecting the currency, with domestic investors likely to repatriate Yen at times of crisis. The last major earthquake to hit Japan was on January 17, 1995 in Kobe. It caused over $100 billion in damage, but the Yen rose over 20% against the US dollar in the following three months, as Japanese government and other investors sold their assets abroad and repatriated the proceeds in Yen back to Japan to support rebuilding efforts.

In the local market, rupee depreciated against the US dollar over the week. Continuing weakness in the stock market, high oil prices and tepid portfolio inflows continued to keep rupee under pressure. The strength of the greenback in the overseas market, added to the pressure on the rupee. Over the week, the rupee-dollar pair traded in the range of 44.97 - 45.285 and rupee depreciated by 0.6% over the week against the greenback.

This week, markets will look forward to the US Federal Open Market Committee (FOMC) meeting, as key event risk for the beleaguered dollar. Interest rate markets predict that the Fed will leave interest rates unchanged through their upcoming rate announcement, but that does not rule out post-event volatility. It is unlikely that the FOMC will make any substantive shifts in its post-decision commentary. Core consumer price inflation remains relatively tame, and it seems improbable that the Fed makes a hawkish shift on price pressures through the foreseeable future.

Strong February employment numbers likewise make it less likely that Fed will take a more dovish shift towards broader economic conditions. Such muted expectations suggest that any surprises could prove especially market moving across US dollar currency pairs.

Recent CFTC Commitment of Traders data showed that speculative traders remain heavily short the greenback against a broad range of counterparts. Though one-sided sentiment does not guarantee that the US dollar will reverse course, any signs of material sentiment shift would likely involve rapid dollar short covering and continued corrections.

Last week’s sharp dollar rally initially suggested that the greenback could recover from an extreme bearish sentiment. Yet short-term outlook has become considerably less clear given Friday’s sharp dollar decline.

It remains important to watch how the greenback starts this week of trading. A key factor to watch is whether the Euro-dollar pair holds its recent highs. If the greenback is able to hold on to its gains, a short-covering-based rally becomes that much more likely.

In the local market, the participants will also follow the mid-quarter review of the Reserve Bank of India (RBI) monetary policy on Thursday. The central bank is expected to raise policy rates by another 25 bps in order to continue its fight against inflation.

While WPI-based headline inflation is expected to ease to around 7.7% in February from 8.23% in January, but it still remains higher than the comfort level of the RBI. Markets are largely expecting a hike in policy rates. The guidance of the RBI on policy rates in future would be crucial. If the central bank sounds hawkish on inflation on the back of rising fuel prices, and hints at higher rates going forward, stock market sentiment will be adversely affected. That could prove negative for the rupee.

Otherwise, rupee will continue to track the US dollar’s strength overseas and will be weighed down by any spurt in the greenback. Any upward pressure on oil prices or worsening of the political situation in the oil producing Middle East and North African countries would also put rupee under pressure. Over the week, the rupee-dollar pair could continue to trade in the range of 45.20 - 45.75.

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