Column

Financial markets last week saw the first step towards normalisation of monetary policy—a theme, which is likely to persist throughout this year.

The People’s Bank of China (PBOC), the Chinese central bank, raised the cash reserve requirement of commercial banks in China, thereby pulling out some of the liquidity injected last year to counter the ill-effects of the global financial crisis. This had a sobering impact on the risk sentiment and appetite of investors globally.

In the currency market, the Japanese yen advanced against all other major currencies as a move to tighten monetary policy by the PBOC sparked fears over prospects for global growth and stoked safe haven demand for the Japanese currency.
Commodity-linked currencies such as the Australian dollar fell sharply against the low-yielding yen after the PBOC move on Tuesday.

Although a large section of the market believed that the move reflected concerns over the rapid expansion in bank credit in China during the first few weeks of 2010, fears that it might herald quicker and more aggressive monetary tightening hit currencies of countries such as Australia that cater to China’s voracious demand for raw materials. Over the week, the yen rose 2.1% against the Australian dollar, climbed 1.7% against the Canadian dollar and gained 1.8% against the New Zealand dollar.

The yen also advanced against the US dollar and the euro as fears over global growth damped expectations that the European Central Bank (ECB) and the US Federal Reserve would raise interest rates sooner-than-expected. The resultant fall in the yield differential between Japanese government bonds and those in the US and the eurozone boosted the yen.

Jean-Claude Trichet, the president of the ECB, indicated that policy rate hike was not close to being on the agenda after the central bank left interest rates at 1% after its monetary?policy?meeting. Trichet said that, with the eurozone facing a “bumpy road” and a “great level of uncertainty”, the current low level of interest rates was appropriate.

A surprise drop in US retail sales in December tempered expectations that the US Federal Reserve would look to depart from its ultra-loose monetary policy stance soon. Over the week, the yen rose 2% to against the US dollar and climbed 2.2% against the euro. The yen also rose 0.5% against the pound over the week.

But the pound advanced elsewhere, rising 1.5% against the greenback and 1.7% against the euro over the week, on hawkish comments from Andrew Sentance, a Bank of England policymaker, and a rise in UK industrial production in November.

Concerns over fiscal problems in Greece undermined the euro against the US dollar, sending it down 0.4% over the week. The single currency and the price of Greek government bonds relative to their German counterparts fell after Trichet gave his clearest warning yet that the ECB would not be giving any “special treatment” to countries that find themselves in fiscal difficulties.

In the local inter-bank market, the rupee finished the week a tad lower against the greenback. The rupee rallied sharply on Monday following US dollar weakness overseas but gave up its gains over the rest of the week as the greenback firmed up globally. The news of monetary tightening in China negatively affected the local stock market and that in turn also pulled the rupee lower.

Demand for dollars from importers too kept the Indian unit in check, despite portfolio inflows from the FIIs touching $1.5 billion during the week. Over the week the rupee-dollar pair traded in the range of 45.28 - 45.82.

Last week’s price action in the currency market offers some pointers to the market momentum and sentiment. A fairly disappointing week of US economic data helped push the US dollar to fairly noteworthy lows against the euro and other major currencies earlier in the week. But a late-week turnaround in market risk sentiment showed that currency markets are not prepared to push the greenback substantively lower. The combination of a drop in non-farm payrolls, lacklustre retail sales data, and a record US budget deficit should have pushed the greenback lower.

Yet budget deficit fears were ameliorated by a successful US Treasury 30-year bond auction and it seems that ballooning government deficit has not had a substantive effect on demand for US Treasuries. The jump in Treasury bond prices underlines the fact that investors still consider the US dollar to be a premier safe haven through times of financial market stress, and the late-week bounce in the dollar only reinforced its position.

A relatively light economic data release calendar this week means the greenback is likely to trade off of broader risk patterns, and it will be critical to monitor any sharp moves in the US equity markets and other barometers of risk sentiment.

In the local market, a combination of stronger-than-expected industrial production data for November and WPI inflation crossing 7% in the month of December has heightened expectations of monetary tightening by the Reserve Bank of India (RBI) in its quarterly meeting on January 29.

While the central bank will indeed go ahead with some liquidity tightening through a CRR hike, policy rate hikes would take some more time and will be gradual. That would further reinforce the yield advantage of rupee-denominated assets and will be beneficial for the Indian unit.

But at the same time higher interest rates could burden corporate earnings and thereby have a negative impact on the stock market. That negative impact could dominate the positive impact from rising interest rate differentials for some period of time.

Otherwise, the rupee will continue to take cues from the US dollar movement overseas, which critically depends on the market risk appetite.

Third quarter corporate earnings announcements would be crucial too, as the stock market is looking for fresh momentum on either side. Overall, the rupee could trade in the range of 45.50-46.10 this week.

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

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