Column

Equities to remain on a slippery ground on the back of cautious mood

Caution persisted in the financial markets last week, amidst announcements of more credit market related writedowns and losses in the US financial sector. This backdrop was clearly negative for equities and carry trades, as risk aversion took hold among investors. Price action in the currency market was influenced by this and as a result, the yen was on a firm footing for most of the week, as market participants got out of riskier carry trades.

On Friday, the news of another US bank securing investment from overseas to shore up its balance sheet cheered up the worried market participants. That saw equities market rallying and the yen take a beating against other currencies.

Otherwise in continuation of its recent show of strength, the US dollar outperformed its major currency peers last week too, as unwinding of bets against the greenback continued. Data showing that inflationary pressures, which remain firmly entrenched in the US economy, also helped the greenback. The core personal consumption expenditure (PCE) deflator, the Fed’s preferred measure of inflation, printed at 2.2% for November (above the Fed’s perceived ‘comfort level’ of 2%), making it harder for the US central bank to cut rates in January.

The pound sterling was the worst performing major currency last week. It dropped to a record low against the euro and a four-month low against the US dollar. The sterling was pulled down sharply on Thursday, as data showed that UK’s current account deficit surged to a record high in the third quarter of 2007.

The current account deficit jumped to £20 billion - far exceeding forecasts of £11.4 billion - due to a substantial widening in the merchandise trade deficit and a marked shortfall in investment income. Furthermore, past figures of the current account deficit were also revised up markedly.

With UK’s current account deficit at its highest-ever level of 5.7% of the GDP now, the structural prospects for the pound are clearly deteriorating. Cyclical prospects for the currency are already under strain, as a near-term cut in interest rates by the Bank of England (BoE) continues to weigh on the pound.

The growth momentum in the UK economy is slowing rapidly, following a decline in the housing market, and therefore rates are likely to fall from their current 5.5% in the New Year. In fact, minutes of the BoE’s December monetary policy committee meeting released on Wednesday, showed that the decision to cut the policy rate in December was unanimously agreed by all members. That reinforced market expectations of two rate cuts in the first half of 2008.

In contrast, market consensus expects the European Central Bank to keep euro-zone interest rates on hold at 4% in the first quarter of 2008, amid concerns over growing inflationary pressures in the region. And even the prospects of a Fed rate cut seem less certain to market participants now than sometime ago. The pound thus can be expected to continue to under-perform these currencies, following expectations of interest rate differentials turning against it.

In the local inter-bank market last week, the rupee tripped against the US dollar. A sharp decline in the stock market, in line with a sell-off in the region and FIIs offloading local assets impacted the Indian unit negatively. The FIIs were net sellers of Indian stocks and bonds to the tune of $908 million last week. The greenback’s strength overseas weighed on the rupee too.

Month-end demand for dollars from oil companies and other importers also exerted downward pressure on the rupee. Exporters took the opportunity to sell their dollar proceeds, as the rupee slipped to lower levels, thereby curbing sharper decline in the value of the Indian unit. Overall, the rupee-dollar pair traded in a range of 39.30 - 39.657 and the rupee fell by 0.5% against the greenback. The rupee also depreciated against the euro but recorded gains against the yen and the pound.

This week, liquidity in the international currency market will be thin due to holidays and therefore the price action is unlikely to be very different from the recent weeks. The US dollar could be expected to hold on to its gains made in the last fortnight. The economic data-release calendars are also fairly light this week, which will only reinforce the status quo in the price action among the major currency pairs.

In the local market, the rupee is likely to find support from some buoyancy in the stock market on Monday. Local stock market could gain following a rally in US and other markets on Friday last week. And equity market action would continue to drive the action in the rupee-dollar pair for the rest of the week too. Given that the underlying mood among investors remains one of caution, equity markets globally could continue to witness volatility and remain on a slippery ground.

Otherwise month-end demand for dollars from oil companies and other importers is likely to keep the rupee under pressure. High oil prices will only add to that pressure. Overall, the rupee-dollar pair could trade in the range of 39.40 - 39.70 this week.

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

E-mail: gaurav.kapur@in.abnamro.com