Column

Weak US economic data could add to the gloomy sentiment, thereby undermining the dollar.

The distress in the US financial sector continues. Last week saw the biggest bank failure in the history of the US. That, along with delay in finalising the details of the $700 billion rescue package heightened risk aversion among investors across markets.

In the currency markets, such sentiments led to the Japanese Yen outperforming its peers while the financial sector turmoil kept the dollar under pressure.

The yen advanced last week as investor risk-aversion climbed on news that negotiations to push the Bush administration’s $700 billion financial rescue package through Congress had stalled, and against the background of the biggest US bank failure.

Authorities shut down Washington Mutual, the largest US savings and loans bank, and sold its assets.

The news pushed investors towards the safe haven of the low-yielding yen, which has been used widely by carry-trade investors to fund the purchase of riskier, higher-yielding assets.

The yen rose 1.3% against the greenback last week, climbed 0.3% against the euro and gained 0.7% against the pound. Against the higher yielding Australian and New Zealand dollars, the yen rose 1.7% and 2.1%, respectively. The Japanese currency’s advance came in spite of figures that showed Japan recorded its first trade deficit for 25 years in August, a sign that the global slowdown was hurting Japan’s export driven economy.

The other low-yielding currency, the Swiss franc, which too acts as a safe haven in times of market turmoil, also gained. It rose 1.3% against the dollar, climbed 0.7% against the euro and gained 0.9% against the pound.

Meanwhile, the dollar stayed on the back foot throughout last week.

But its losses were limited amid signs that the effects of the credit crisis were spreading across the globe. Forecasts that the Eurozone was headed towards recession were reinforced as business confidence dropped across the region. Over the week, the greenback fell 1% against the euro and lost 0.7% against the pound.

In the local market, the rupee depreciated by 1.6% against the dollar. The Indian unit was undermined by a sharp slide in the equities market, month-end demand for dollars by importers along with another weekly jump in crude oil prices.

The news of relaxation of external commercial borrowing controls for infrastructure companies also failed to support the rupee. The market reaction to some relaxation of capital controls was muted, as, given the current state of global capital markets — especially the liquidity crunch — raising offshore loans at a reasonable cost would be difficult.

Most of the rupee depreciation occurred in the second half of the week. The Indian unit opened the week stronger, helped by a decline in the greenback. However, as the week progressed, domestic factors took hold of the price action. The slide in equity markets gathered momentum on the back of global risk aversion. Over the week, the Sensex dipped by 6.7%. The Reserve Bank of India had to continue supporting the rupee. It sold dollars to bridge the demand-supply gap.

The oil marketing companies were in the market to buy dollars to meet their month-end requirements. Foreign Institutional Investors remained net buyers of local stocks and bonds over the week, but most of their buying occurred in the first two days.

Overall the rupee-dollar pair traded in a wide range of 45.235-46.58 last week. In the rupee-dollar forwards market, premia declined further, as spot rupee weakened while interest rates remained broadly unchanged from their previous week’s levels.

This week promises to be a more eventful week, with the US economy at the epicenter of all action.

The US treasury is likely to announce the operational details of the proposed bailout plan for buying distressed assets. That will help purge some of the near-term concerns. However, the long-term economic consequences of this crippling period would continue to be priced in. Many market participants had believed the US economy was heading for a recession even before this fundamental stress was added.

In recent weeks, those dour growth forecasts have only been bolstered, further boosting the probability of a rate cut by the Federal Reserve.

Fed fund futures are fully pricing in a 0.25% rate cut for the October 29 meeting, and there is a 32% chance the US central bank will slash the key rate by 0.50%.

While the financial crisis and expectations of a Fed rate cut will remain the major influences driving the value of the greenback over the near future, a host of important macroeconomic data releases this week will also play a part.

Topping the list is the monthly non-farm payrolls report. This indicator has been put on the back burner recently, but an expected ninth consecutive contraction would draw further comparison

to the employment conditions back in 2001-02 — during the US’s last recession.
Other indicators will offer a broad gauge of economic activity through the third quarter. Consumer spending, which accounts for an estimated 80% of US GDP growth, will be measured through household-level consumption expenditure, income and spending indicators. Other growth readings will come in the form of the ISM manufacturing and service sector reports — both readings are expected to have contracted through September. Broadly, it appears that the dollar could remain under pressure this week too.

A weaker greenback needs to be very helpful for the rupee at present. The broad movements of the greenback have an asymmetric impact on the rupee.

The dollar rally overseas pulled the rupee down, but a slide in its value now would not be too helpful considering, that a weaker greenback leads to higher commodity prices, particularly oil. That adds to the already strong pressure on the rupee through a widening trade deficit at a time when capital inflows are down to a trickle.

On the positive side, any improvement in risk appetite would help local equity market recover and that would help the rupee.

The Indian unit will continue to require RBI support to counter depreciation pressures. This week, the rupee-dollar pair can trade in the range of 46.00-47.00.

The author is senior economist, ABN Amro Bank. Views expressed herein are personal. gaurav.kapur@in.abnamro.com