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Dollar shortage, high oil prices and weak equities to keep the rupee under pressure

The US economy is beginning to show signs of tipping into stagflation. The strength of the economic activity continues to weaken while inflation is picking up.

The US Federal Reserve wants to avoid a recession and therefore has been cutting rates aggressively. However, last week’s US data showed that the rate cuts are not yielding the desired results and it seems that the Fed is poised to cut rates even more.

In fact, over the last week the markets raised the chances of another 0.75% cut in the Fed funds rate in March. Such expectations pushed the US dollar to a new low against the euro and the Swiss Franc and it weakened against a host of other currencies too.

A sharp rise in the price of dollar-denominated commodities, specifically oil and gold, however make the Fed’s job more difficult. Inflationary pressures in the US are only intensifying with a decline of the dollar.

The slew of US data releases last week acted to push the greenback down to new lows. Flat economic growth in the fourth quarter, tumbling house prices, falling consumer confidence, weaker-than-expected durable goods orders and signs of weakening labour market drove expectations of lower interest rates.

Further complicating the issue, inflation reported by the PCE deflator accelerated to its fastest pace in over two years.

The dollar sold-off sharply on Wednesday, particularly against the euro, after euro zone data supported the view that the European Central Bank would keep rates on hold for some time. Ben Bernanke, Fed chairman, turned the situation grimmer for the dollar after he promised “timely” action to “provide adequate insurance against downside risks”.

The greenback’s fall drove commodities higher. Gold and oil hit fresh records, with the latter closing above $100 a barrel. Speculation rose that for inflation-targeting central banks such as the ECB, that trend could even open the door to higher interest rates.

Supported by this premise, the Euro rose to a new high and over the week the single currency gained by 2.3% against the greenback. The Swiss franc also hit a record against the US dollar and stood up 3.7% on the week.

The Japanese yen also had a handsome 3.1% rally against the greenback. Risk aversion among global investors on the back of more bad news related to the credit crisis helped the greenback to some extent, as flight-to-safety saw investors piling up US treasuries.

The pound, however, was held back by concerns about the UK’s economy. Fourth-quarter GDP growth printed at 0.6%, but showed a fall in household spending and looked to be over-reliant on government expenditure.

Also, the Nationwide House Prices indicator for February reported the fourth consecutive monthly decline in residential inflation - the worst trend from this series since the beginning of this decade.

Over the week sterling gained 1% against the US dollar, but slumped 2.1% against the yen. The euro also rose to a record high against the pound on Thursday and finished the week up by 1.3%.

In the local inter-bank market, the rupee finished the week largely unchanged against the dollar. The Indian unit strengthened in the first half of the week, as the cash dollar supply in the banking system improved.

The RBI rolled over its forward dollar purchases by selling dollars and buying them back in forwards markets, in order to alleviate the dollar shortage. That reduced the pressure on the spot rupee.

On Wednesday, the central bank bought dollars quiet aggressively in order to avoid rupee appreciation following dollar’s sharp decline in the global market. Towards the end of the week, however, rupee slipped again on covering of short dollar positions by banks, noting aggressive RBI intervention in the spot market and fearing reoccurrence of cash dollar shortage. High oil prices and FII outflows also created demand for dollars.

The most important policy event in the Indian calendar, the Union Budget announcement, did not have much impact on the rupee. However, continuing fiscal consolidation, a largely unchanged tax code, a slew of initiatives for the agriculture sector and boost to consumption spending, would be helpful in maintaining the growth momentum in the economy and thus keep it attractive for foreign investment.

That will be positive for the rupee in the long run. Overall the rupee-dollar rate traded 39.70 - 40.08.

This week too the rupee would receive support from the dollar’s weakness. Among the key US data releases due includes ISM manufacturing index and the non-farm payrolls report. It is quiet likely that these data points will only confirm the fears of the US economy tipping towards a recession.

That would leave the market expecting more rate cuts by the Fed. However, persistence of cash dollar shortage in the local market, placid capital inflows, jittery equity markets and record high prices of oil and other commodities, would counter the appreciation pressure on the rupee.

The RBI also seems keen to prevent the rupee from appreciating past 39.70. Overall, the rupee-dollar pair is likely to trade in the range of 39.80 - 40.20 this week.

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