Dollar could resume fall in first quarter of 2010

As 2009 draws to a close, the financial market turmoil seen at the start of year has abated and the global economic recovery looks to be on track. However, there is still considerable uncertainty surrounding what may happen in 2010, especially in the currency markets.

The biggest uncertainty facing the markets is the pace at which the central banks, especially in the G4 countries may withdraw monetary support and remove the excess liquidity prevailing in the global financial markets.

The US dollar has strengthened since the start of December against a backdrop of US economic data that was stronger than expected, including a surprisingly robust employment report and upturn in consumer price inflation.

This has encouraged the view that the US Federal Reserve will depart from its ultra-loose monetary policy stance sooner than expected, lessening the attractiveness of the greenback as a funding currency in carry trades.

Before this month’s US dollar rally, the sell-off in the currency from March until the end of November was built upon both a rebound in global economic activity and loose liquidity conditions which encouraged strong capital outflows from the safe haven of US government securities into higher-risk assets such as equities, emerging markets and commodity-linked investments.

At the end of 2009, equity markets remain around their yearly highs. This implies that the underlying tone in the market, going into the first quarter of 2010, remains skewed towards more risk-taking.

Moreover, with ongoing economic recovery and the G4 central banks maintaining their accommodative monetary policy stances in the foreseeable future, ample liquidity will ensure that the greater risk appetite driven-carry trades can continue. This suggests some further upside for risky assets in the first quarter of 2010.

However, for the US dollar this means its downtrend will resume. Despite better US data, the Fed won’t be in a hurry to start raising rates. Inflation remains subdued and the central bank will want to see how the end of its quantitative measures is absorbed by the market before starting any rate hike cycle.

This suggests expectations will not tighten around Fed rate hikes until later in June 2010. The greenback will struggle to perform well until then. With liquidity thin into year-end, there have been some volatile moves in currency markets over the past few weeks.

While the US dollar has been the main beneficiary, the euro has been a notable underperformer amid fresh worries over the outlook for Greece in the aftermath of the ratings downgrade by ratings agencies S&P and Moody’s. The recent announcement of the 2010 Budget in Greece did little to allay fears that the government will not and cannot get a grip on the budget deficit.

However, the downgrade has also raised concerns that Greek banks could become ineligible for the European Central Bank’s (ECB) liquidity operations, if the ECB reverts back to old eligibility criteria.

Greek paper may not be eligible for the ECB refinance operations with sovereign rating at BBB+ now, as the central bank normalises these operations. This is very unlikely though going into the next year. Greece is going to have to respond to European Commission demands on the budget deficit, however ultimately the EU and ECB are likely to bail out Greece.

This will be supportive for risk appetite, but the prospect of the ECB having to nurse Greece, as well as other European Union periphery countries, through their growing troubles, does raise headwinds for the euro in 2010.

In the local inter-bank market, the rupee appreciated against the US dollar as capital inflows, especially through the portfolio route picked up over the year and trade deficit narrowed on the back of lower oil prices and generally depressed non-oil imports.

The extent of appreciation was however, muted by the fact that depressed external demand severely affected exports and capital inflows from sources other than portfolio flows remained relatively muted. For instance, external commercial borrowings averaged at around $1.5 -2 billion per month. Moreover, a resurgent US dollar kept the rupee in check too.

The Indian unit appreciated by 3% against the greenback over the year.  Going ahead, while bias is towards a weaker greenback in the first half of 2010, prospects for higher interest rates locally and better a growth outlook in this fiscal and the next, could keep the bias for appreciation of the rupee intact.

The extent of appreciation will however, critically depend on capital inflows. But with portfolio inflows remaining the main source of capital inflows, price action in the rupee-dollar pair could see heightened volatility depending on the global investor risk appetite.
That in turn could curb the extent of appreciation of the rupee.

And, with oil prices also having bottomed out and economic activity improving, merchandise trade deficit pressures on the rupee could mount with rising imports. This week, the rupee-dollar pair could continue to trade in the range of 46.40-47.00.

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