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Currency markets saw heightened activity last week following a landmark decision by the US Federal Reserve. The US dollar tumbled, hitting a three-month low against the euro and a 13-year trough against the yen, as the Fed cut the overnight Fed funds rate to virtually 0% after its monetary policy meeting.

On Tuesday, the Fed said it was establishing a new target range of 0% to 0.25% for its main Fed funds lending rate.

The US central bank said it would “employ all available tools” to promote the resumption of sustainable economic growth, adding that weak economic conditions were likely to warrant exceptionally low levels of interest rates for some time.

The greenback sold off aggressively on the news that the Fed had, in effect, adopted a quantitative easing approach to monetary policy. Under the approach, the Fed will be pumping money into the financial system directly now that interest rates were virtually zero. Between 2001 and 2006, the Bank of Japan also followed a similar policy, which ultimately gave rise to the yen-funded carry trades.

The US dollar had been supported since mid-September, driven by a scarcity of dollar liquidity in global markets, repatriation flows from US investors and the closing of positions by investors who had funded investment in riskier assets by shorting the greenback. However, more stable dollar-funding conditions in the money market have limited the demand for dollar liquidity globally.

An improvement in risk appetite has also limited the investor repatriation and short covering demand for the greenback. That too is leading to a correction in the value of the greenback.

The US dollar did recover some ground on Friday, pulling away from its lows, as investors took profit after a volatile week. But, over the week, the greenback fell 4.8% against the euro, which received support from hawkish comments from European Central Bank officials. It also fell 2.2% against the yen and dropped 6.3% against the Swiss franc.

The greenback was largely unchanged against the pound over the week, as expectations for further rate cuts from the Bank of England (BoE) continued to undermine the Sterling. The pound tumbled to a series of record lows against the euro after the minutes of the BoE’s December monetary policy meeting revealed that it had considered an even more aggressive interest rate cut than the 1% cut that took rates to 2%.

Pound was further undermined following remarks from the deputy governor of the BoE, Charlie Bean.

He said a 0% interest rate policy in the UK was possible and that the UK government was likely to pump billions of pounds into the banking system.

This heightened expectations that the UK was set to become the next country to follow the US and adopt a quantitative easing approach to monetary policy.

The pound hit a record low against the euro on Thursday before retracing some of its losses on Friday. Over the week, the pound dropped 5% against the euro and fell 2.4% against the yen.

In the local market, the rupee also appreciated by another 2.5% against the US dollar, adding to its gains in the month of December. Supportive conditions helped the rupee to a 2-month high against the greenback during the week. Equities gained by 4.2% over the week helped to some extent by FIIs remaining buyers of local stocks. In December so far, the FIIs have bought Indian assets worth $659 million.

In another important development, oil price fell 23% over the week—one of its biggest ever falls—in spite of OPEC, the cartel of oil producing nations, deciding to cut production. Fears of a deep recession had outweighed the prospect of reduced supply.

Most importantly however, greenback’s slide, especially against other Asian currencies, was the main factor behind rupee appreciation. Dollar slide is also helping shore up the value of the RBI’s foreign exchange reserves. Latest foreign reserve data showed an accretion of $4.8 billion to the reserves in the week ended December 12.

That can largely be attributed to valuation gains made by the Indian central bank due to an appreciation in the dollar value of its non-dollar assets holdings.

This week, the price action in the currency market could see some consolidation in the US dollar, after having fallen sharply so far this month. The $17.4 billion bailout package for US car markers would help counter the fears of a deep recession in the US economy. Moreover trading volumes will thin as we approach major holidays towards the year-end. We could thus see heightened volatility, especially in response to any macro-economic evidence on the worsening state of the US economy. The broad market bias could still be dollar bearish this week.

In the local market, rupee is likely to find it tough to breach the level of 46.92 it closed on Friday last week. That market conditions would remain favourable for the rupee to hold on to its gains over recent weeks.

Market sentiment for one will remain positive on hopes that rapidly declining inflation would prompt the RBI to cut rates soon, which, in turn, will prop up the economy.

The government could also announce the second phase of the economic stimulus package. However, trade deficit-related pressure in light of shrinking external demand would continue to weight on the Indian unit. Overall the rupee-dollar pair can trade in the range of 47.00 - 48.00 this week.

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