Strong dollar likely to weigh on rupee

Rising US treasury yields and flight to safety by investors is helping the greenback.

Financial markets were driven by inflation concerns particularly in the emerging markets, interest rates and geopolitics last week.

Market participants navigated through a move of further tightening by China and the resignation of Egypt’s president, as well as a re-emergence of eurozone debt fears.

Equity markets in the US and Europe struck two-and-a-half-year highs, even as their emerging market counterparts traded around two-month lows and headed towards their worst weekly performance since May.

Underpinning the shift away from emerging market assets has been the fear that mounting inflationary pressures in many economies, particularly from food prices, will force central banks to raise interest rates — putting growth at risk.

China last week increased its benchmark rates by 25 basis points, the third such move since October.

Meanwhile, eurozone debt concerns came back to market focus once again as the yield on Portugal’s 10-year government bond touched a euro-era high, prompting the European Central Bank to intervene in the markets.

In the currency markets, the US dollar advanced last week as rising US Treasury yields, worries over emerging-market inflation and continued turmoil in Egypt boosted the greenback.

The rise in US Treasury yields reflected rising optimism over the US economy. The expected improvement in US growth helped prompt a steepening of the Treasury yield curve. 

The yield on 10-year Treasuries hit its highest level since April. This helped lift the US dollar against the low-yielding yen and the Swiss franc in particular, as carry trade investors switched away from funding their purchase of high-yielding riskier assets through greenbacks.

Over the week, the US dollar climbed 1.5% to a one-month high against the yen and rose 1.9% to a four-week peak against the Swiss franc.

The greenback also rose 0.6% against the pound over the week and climbed 0.3% against the euro, with the single currency coming under pressure as fears over peripheral eurozone debt resurfaced.

Fears that Portugal might be forced to seek international financial assistance weighed on the euro.

Also supporting the US dollar were concerns over rising inflation in emerging markets, which were highlighted as China raised interest rates for the second time in just over six weeks.

This, along with continued uncertainty in Egypt, prompted market participants to continue to withdraw funds from emerging markets, with repatriation flows lifting the greenback.

This shift hit commodity-linked currencies, which have benefited from robust emerging market demand for raw materials. Over the week, the Australian dollar dropped 1.1% against the US dollar, while the New Zealand dollar dropped 1.1%.

In the local inter-bank market, the rupee weakened a tad against the US dollar. The Indian unit was under pressure from the sliding stock market and FII outflows.

The BSE Sensex slid by 1.6% over the week and FIIs remained net sellers of Indian stocks and bonds by $467.7 million. The rupee however, tracked the US dollar movements against major currencies closely.

The Indian unit gained value as the greenback fell overseas in the first half of the week. Later in the week, as the US dollar recovered the rupee too lost value. Over the week, the rupee-dollar pair traded in the range 45.23-45.78 over the week and the rupee lost 0.2% value against the greenback.

This week a slew of key US economic data releases and the subsequent event risk promise considerable volatility in the currency markets and financial markets at large.

Advance retail sales data (a gauge of the strength of US consumer), Federal Open Market Committee (FOMC) minutes of the last meeting, and consumer price index inflation figures could spark substantive market reactions on any surprises.

Markets continue to speculate on whether the US Federal Reserve will soon move to reduce extensive monetary policy stimulus amidst encouraging signs for growth.

Recent rhetoric from Federal Reserve chairman Ben Bernanke made it clear the Fed has little intention to reduce extraordinary quantitative easing policies amidst sluggish employment growth.

It will be interesting to watch whether Thursday’s consumer price index based inflation figures will put pressure on the Fed to act on growing price pressures.

Any strong surprises on the higher side would embolden the hawkish minority within the policy-setting FOMC.

The US dollar otherwise seems to be at somewhat of a crossroads. After falling sharply into early in during last week, a substantive later reversal suggests that the beleaguered currency may have set an important low against the Euro and other counterparts.

This week of important data would decide whether this reversal can hold going ahead.

In the local market, rupee would continue to track the movements of the US dollar overseas. Importantly, there was some disconnect visible between the stock market movements and the rupee-dollar pair last week.

It remains to be seen whether this persists, as rupee has been closely tracking the movements in the stock market in recent years.

Otherwise, improving momentum in exports is encouraging as that would help reduce the merchandise trade deficit going ahead.

Exports registered 32.5% y-o-y growth in January on the back of improving global growth conditions. Robust external demand would help the rupee in the medium term.

Over this week however, the rupee can continue to trade with some depreciation bias, as the greenback can maintain some strength in the overseas markets. The rupee-dollar pair is likely to trade in the range of 45.40-46 over the week.

(The author is senior economist, Royal Bank of Scotland NV. Views expressed herein are personal. E-mail: gaurav.kapur@rbs.com )