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Some more indications of an improvement in economic and financial conditions came in last week. Most notable among them were the strong Chinese industrial output data and news that 10 US institutions would be allowed to repay the Treasury bailout funds.

Fresh signs also emerged that the recession in the UK economy might have bottomed out. The National Institute of Economic and Social Research said the UK economy had troughed in March, while house price data showed more signs of stabilisation.

US interest rate futures started to price in a Federal Reserve tightening by the end of this year, following signs of economic improvement. Such optimism helped fan speculation of a pickup in demand for commodities, boosting oil and base metal prices to new highs.

In the currency market, the pound rose to its highest level of the year against the euro and advanced against the US dollar last week, as hopes grew that the UK economy might be responding to aggressive monetary policy loosening.

UK house prices showed continued signs of stabilisation. Also growth was registered in the industrial production numbers for the first time in 14 months.

Adding to support for the pound was the receding political turmoil in the UK. The pound rose 2.5% against the euro over the week, its strongest level since early December, and gained 2.9% against the dollar.

Meanwhile, the US dollar edged lower over the week, as the currency market’s attention focused on the sharp increase in US Treasury yields.

The move initially played in the greenback’s favour as investors speculated that the Federal Reserve could move to raise interest rates, possibly by the year-end.

That view was reinforced by comments from Jeffrey Lacker, president of the Richmond Federal Reserve, who issued a warning on Wednesday over inflation, saying the US Fed should not delay in tightening monetary policy once the economic recovery began.

The greenback quickly reversed course as fears over the ability of the US to attract funds to finance its growing fiscal deficit took hold. Those fears were exacerbated on the news that both Russia and Brazil were planning to invest $10 billion in bonds issued by the International Monetary Fund denominated in Special Drawing Rights, a currency basket containing about 44% dollars.

This heightened concerns that international reserve managers were set to diversify away from the US dollar.

However, comments from Japan, the second-largest holder of US Treasuries after China, and a successful US Treasury auction allayed some of those fears.

Japan’s finance minister, Kaoru Yosano, said his trust in US Treasuries was “absolutely unshakeable”.

Over the week, the US dollar fell 0.4% against the euro, eased 0.2% against the yen and lost 0.6% against the Swiss franc.

Commodity-linked currencies advanced strongly last week, as commodity prices rose further during the week. The New Zealand dollar rose 2.5% against the dollar on the week while the Australian dollar gained 2.4%.

In the local inter-bank currency market, the rupee slipped by over 1% against the US dollar on the back of rising oil prices. Crude oil prices rose by more than 5% during the week, crossing $70 per barrel mark, as the International Energy Agency raised its oil demand forecast for this year.

Otherwise conditions remained broadly supportive of the rupee. FIIs remained net buyers of local stocks and bonds, with their net purchases last week amounting to $893 million. However demand for dollars from oil companies exerted pressure on the rupee. Overall the rupee-dollar pair traded in the range of 47.225 - 47.775. Going forward, risk trends would continue to play an important role in influencing the price action in the financial markets.

Recent months have shown that it is not the fundamental data that define, revive or reverse trends but speculation surrounding the financial health of the US economy compared to its global counterparts and broad risk sentiment.

While risk appetites are being built again, market participants would now look for any guidance or information from governments and central banks in developed countries on their exit strategies to unwind the temporary support through very accommodative monetary policy and expansionary fiscal policies.

For the US dollar in particular, the timing of a change in policy is critical.

If the US Treasury and Federal Reserve move too soon to withdraw their support, another bank implosion could set off another crippling seizure through the credit market.
Alternatively, move too slow and expansion across the rest of the globe will devalue US assets and the greenback due to a massive budget deficit.

Not only could this divert capital flows away from the world’s largest economy, but it could also be reason to revive talks for replacing the greenback as the world’s reserve currency. These are long-term concerns, but each event would force the market to speculate on either of these outcomes.

This week’s critical events include the release of the US May housing starts and industrial production numbers.

To support speculation of an economic recovery, improvements will be expected. The TIC data on capital flow into and out of US would also be keenly followed as the US Treasury continues with record issuance of bonds to fund a massive fiscal deficit.
In the local market, high oil prices would continue to exert pressure on the rupee.

Moreover with equities market now range bound and portfolio inflows in the positive for sometime now, market participants are likely to focus more on the adverse impact of oil prices on the rupee. Overall the rupee-dollar pair could trade in the range of 47.25 - 47.75 during this week with a mild appreciation bias.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal.