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Positive news from the US is likely to push up dollar further

Currency markets the world over continue to witness a resurgence of the US dollar. After the US Federal Reserve started cutting interest rates in September last year, the greenback fell sharply. The euro and the yen in particular gained as a result.

But over the last three successive weeks now, the greenback has started recovering the ground it lost. One of the main reasons for that is the market expectation that the Fed, after aggressively cutting rates, is at the end of the easing cycle. Such expectations have been formed on the back of signs that the worse of the credit market crisis induced turmoil in the financial system might be behind us.

Last week, the Fed, while reducing rates by another 0.25%, signaled a neutral bias in the near future. The interest rate futures market is now pricing in a scenario of “status quo” on rates over the next two months, with over 70% probability.

Data releases from the US also seemed to suggest that even the economy is beginning to respond to the monetary stimulus provided by the Fed.

Throughout this past week, there were a number of upside surprises in the data releases, including non-farm payrolls report, first quarter GDP and manufacturing ISM index. Most significantly, for the first time in the last four months the non-farm payrolls report beat expectations, showing only 20,000 job cuts instead of the forecasted drop of 75,000.

For the Fed, this is a welcome improvement because it validates their neutral bias and indicates that their efforts to date are mitigating some of the risks to economic activity.

Backed by these surprises, the US dollar witnessed a powerful rally. The euro, in particular, registered sharp losses against the greenback.

Weaker-than-expected economic activity data from the Euro-zone heightened expectations that the European Central Bank might shift to a more dovish stance on interest rates, just as the Fed moved into neutral. The euro was down 1.3% over the week against the greenback and it fell 0.6% against the pound.

Continuing improvement in risk appetite saw the Japanese yen sell off heavily last week. It fell 0.9% against the US dollar over the week.

Earlier in the week the Bank of Japan struck a more dovish tone than expected, in spite of rising inflation. High-yielding currencies such as the Australian dollar and the New Zealand dollar moved sharply higher against the yen after a pick-up in carry trade activity. The Aussie, which had steadily sold off over the week as commodity prices fell, spiked on Friday to finish 1.1% higher against the yen. The New Zealand dollar rose by 0.8% against the yen.

In the local market last week, the rupee also fell sharply against the greenback.

The rupee-dollar pair traded in a range of 40.115 - 40.77, with the rupee falling by 1.3% against the greenback. Month-end demand for dollars by oil importers along with the greenback rally put the Indian unit under considerable pressure.

The data released last week also showed the pressure India’s growing merchandise trade deficit is exerting on the rupee. During fiscal year 2007-08, trade deficit widened to $80.4 billion, larger by 35.5% from the previous fiscal year.

Supply of dollars through the capital inflows remained muted.

The most important event of the week for local market participants was the announcement of the RBI monetary policy for the current fiscal year. The central bank raised the banks’ cash reserve ratio (CRR) by another 0.25% in an effort to curb inflation without hurting growth. The RBI also aims to bring down the broad money supply growth within a range of 16.5 - 17% during FY09, compared to 21.2% currently. While slower bank credit and GDP growth rate would help in reaching that target, further CRR hikes can also be resorted to. Even from inflation management perspective, more monetary tightening is highly likely, considering that inflation has climbed to a 42-week high of 7.57%.

The impact of monetary tightening through CRR on the rupee is ambiguous. On one hand, by reducing the supply of rupee liquidity, it helps the unit to strengthen. But on the other hand, a higher CRR enhances the RBI’s ability to intervene in the currency markets, without having to sterilise rupee liquidity through bond sales.

This week too rupee is likely to remain under pressure. The greenback’s recent stellar performance can continue, as no major data releases are due from the US this week.

On the other hand, the ECB will hold its monetary policy meeting and therefore the euro runs the risk of witnessing a further slide on any dovish statements. A stronger dollar would help to keep a lid on commodity prices though.

At the moment however, the rupee is reacting much more to the US dollar’s strength against the Asian currencies. Also the trade related pressures from commodity prices remain at elevated levels. The rupee could draw some support from the equity market.

Increasing risk appetite could see portfolio inflows pick-up. Overall the rupee-dollar pair could trade in a range of 40.50 - 41. 00.

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