Weak economic fundamentals make rupee prone to sharp declines

In the financial markets, investor confidence and risk appetite was buoyed as hopes for global growth were heightened by robust US corporate earnings and strong data from the Euro-zone.

The sentiment however, improved only later in the week. Growing risk appetite led to a rally in global equities and commodity prices and a slide in the US dollar. At the start of the week, risk appetite was dampened by a potential restructuring of Greek government debt and a downgrade in the outlook for US government debt by rating agency Standard & Poor’s. S&P reaffirmed US long-term debt rating at AAA, but revised their outlook on the country’s debt from neutral to negative.

This indicates a one-in-three likelihood that the debt rating will be lowered from AAA within the next two years.

In the currency markets, the greenback plunged to its lowest level in more than two-and-a-half years last week as rising risk appetite prompted market participants to sell the greenback to fund carry trades.

This along with the prospect that the US Federal Reserve would keep interest rates at ultra-low levels for the foreseeable future increased demand for carry trades funded by borrowing in dollars.

Rumours that the People’s Bank of China was poised for a substantial, one-off revaluation of the Yuan also weighed on the US dollar. Over the week, the greenback itself slid 0.9% to a 16-month low against the Euro and fell 1.2% to a 16-month trough against the Pound.

The dollar index, which tracks its progress against a basket of six leading currencies, fell 1% over the week, having been down to its weakest level since August 2008 on Thursday and within sight of the record low of 70.698 it hit in March 2008.

The euro rose as reports showed Europe’s services and manufacturing growth unexpectedly accelerated in April, suggesting the region’s economy is weathering surging energy costs and austerity measures.

The US dollar also fell to a three-week low against the Yen on speculation the Fed will reiterate its intention to keep interest rates near zero when it meets to review monetary policy this week, damping the appeal of dollar assets.

The Australian dollar, the largest gainer last week among major counterparts to the greenback, climbed to a record as stock and commodity price gains drove investors to higher-yielding currencies. The Aussie dollar rose 1.6% over the week after climbing to its strongest level since it was freely floated in 1983.

Asian currencies also strengthened against the US dollar, with Singapore’s dollar reaching a record and Malaysia’s ringgit a 13-year high, on speculation that regional central banks will keep raising interest rates to curb inflation. Chinese Yuan climbed to the highest level since 2007 on speculation that the PBoC may allow faster currency gains to help temper inflation.

The Bloomberg-JPMorgan Asia Dollar index rose to its highest level since 1997.

In the local inter-bank market, the rupee however, closed the week almost unchanged against the greenback, despite positive momentum from general movement in Asian currencies. Weaker external fundamentals, slower portfolio inflows and rising oil prices weighed on the Indian unit. Over the week, the rupee-dollar pair traded in the range of 44.24 - 44.695 and rupee depreciated marginally against the greenback.

Looking ahead, while fundamental conditions have not deteriorated markedly for the US dollar over the past few weeks but sentiment surrounding the greenback certainly has.

With market participants looking for a consistent strategy to take advantage of low interest US rates while broader capital markets seem to struggle for direction, the greenback-funded carry trade has turned into the most favoured trade.

There are a few drivers due this week that can temporarily alter the greenback’s direction. But to alter US dollar’s course would require a deeper fundamental shift. Prevailing trends can hold up but there could be changes in the market backdrop.

The most immediate threat to the bearish dollar trend is a meaningful change in risk appetite. This is one possible driver that can have a lasting impact on the greenback. The potential catalysts for risk appetite are varied.

Market participants would keep an eye on the financial situation in the Euro-area, the excess capital flow in the emerging markets and the buoyancy of equity markets.

A more important driver would be the US GDP data for the first quarter of 2011 due for release this week.

While policy makers have maintained cautious assessment of the US economy’s health owing to employment and depressed performance in various sectors, the robust growth readings have given a conflicting signal for marketmen.

If GDP growth is greater than the consensus market projection of 1.9% annualised growth (down from 3.1% in the previous quarter), the US dollar could rise. A negative surprise on the GDP growth front and a slip in risk appetite will however, struggle to support the greenback for long.

To truly put it on a bullish path, the appeal for the dollar denominated assets needs to change. The best way to do that is change expectations for its inherent yield.

More important than the US GDP report this week is the Fed rate decision. There is almost no chance of a change to the benchmark rate or the quantitative easing program. But this meeting is different than those of the past few years. The Fed chairman Ben Bernanke will start his post-decision, quarterly press conferences, which could provide the market some guidance on the policy rates path in the US.

The rupee seems to have lost the appreciation momentum seen in recent weeks on the back of worsening of economic fundamentals. Rising oil continue to impinge on the rupee. At the same time robust non-oil imports growth is adding to the pressure on the Indian unit through rising merchandise trade deficit. The rupee is receiving some support from the improving export growth momentum. Export growth in recent months has been quiet buoyant. 

On the capital inflow front, portfolio inflows have slowed down in comparison to the rush seen since the end of the March. Market participants would therefore eagerly watch the fourth quarter corporate earnings in order to gauge the strength of FII inflows.

Generally stronger earnings would bolster the case for foreign investors to increase their exposure to the Indian stock market.
Otherwise, the rupee remains prone to sharp decline, especially in case of a reversal in the overstretched US dollar. This week the rupee-dollar pair may trade in the range of 44.25-44.70.

— The writer is senior economist, Royal Bank of Scotland NV and can be reached at gaurav.kapur@rbs.com. Views are personal