Dollar may be developing a meaningful bullish trend

Sovereign debt risk and the possibility of a default from heavily indebted countries came back as the key market theme last week. This focus had intensified following Dubai’s announcement of a debt standstill last month. Fitch, the ratings agency, cut Greece’s credit rating last week and Standard & Poor’s downgraded its outlook on the rating of both Spain and Portugal. The euro suffered as a result on concerns over the health of the public finances of several of the single currency’s member states.

The ratings action news highlighted fiscal problems in other euro-zone countries — such as Ireland — that are struggling with debt burdens and caused some to question the viability of the single currency and the European Monetary Union. Over the week, the euro lost 1.5% against the dollar, fell 3% against the yen and dropped 0.3% against the pound.

The pound lost ground elsewhere, however, as concerns also grew over the UK’s fiscal situation. The UK government’s pre-Budget report focused concerns on the health of the country’s finances, with Alistair Darling, the UK chancellor of the treasury, doing little to address the rising fiscal deficit. Over the week, the pound fell 1.2% against the dollar and dropped 2.7% against the yen.

Meanwhile, the dollar was mixed, rising 1.8% against the Swiss franc on the week, but losing ground against commodity-linked currencies. The greenback fell 0.2% against the Canadian dollar, but gained 0.4% against the Australian dollar.

The New Zealand dollar was the star performer, rising 1.2% against the dollar on the week after the Reserve Bank of New Zealand sounded a hawkish note after its policy meeting, suggesting that interest rates could rise sooner than expected. The NZ dollar also rose 0.7% against the yen on the week.

The yen had suffered a week before last after the US employment report came in much stronger than expected, prompting speculation that the Federal Reserve might seek to abandon its ultra-loose monetary policy stance sooner than expected. This weighed on the yen as market participants reasoned that rising US yields would lead to a switch from the greenback to the yen to fund carry trades. But the Japanese unit recovered last week as the difference in government bond yields between the US and Japan narrowed, following a renewed pledge from Fed chairman Ben Bernanke to keep US interest rates at low levels for an “extended period”. The yen rose 1.5% against the dollar over the week.
In the local inter-bank currency market, the rupee too weakened against a resurgent dollar. The unit was also undermined by tightening of the external commercial borrowing norms by the RBI and weaker-than-anticipated industrial production numbers.
The equities market also finished the week flat after witnessing some volatility, further highlighting the lack of any sustainable support for a stronger rupee at this point of time. The rupee-dollar pair traded in the range of 46.39—46.865 and the Indian unit finished lower by 0.5% over the weak.

The dollar has produced notable rallies at the end of each of the past four weeks. The past two advances are the most notable. Both have come on the back of exceedingly strong economic data. This would contradict the normal price action that the greenback has seen over the past nine months, where strong economic data has bolstered risk appetite and directly weighed on the greenback as a safe haven currency.

With the dollar looking for strength through various market conditions, the currency may be developing a meaningful bullish trend. A collapse in risk appetite that balances speculative interests through profit-taking is still the most important driver for the dollar. Not only would capital return to the safety of US treasuries, it would be drawn out of emerging markets and other risky areas.

In this week’s economic events calendar is a meeting of the Fed’s rate-setting committee. The futures market is targeting the Fed’s first hike around the middle of the year — in line with Bernanke’s time frame. The Fed rate decision on Wednesday will offer an update on how close a hike may be. Also interesting in this event will be any mention of more measured changes to policy, such as the slow withdrawal of stimulus. Other noteworthy indicators include the CPI inflation, industrial production, housing starts and the vote to lift the fiscal deficit limit.

In the local market, the strength of the dollar overseas will continue to weigh on the rupee. And with support from the equity markets also looking muted, that could act as a pressure point for the Indian unit. Moreover, with recent data having highlighted that growth conditions in the economy remain mixed at best, the RBI could delay its monetary tightening process. Indeed, last week’s industrial production data pointed out that manufacturing activity is losing some momentum after witnessing a sharp recovery over the second quarter of the current fiscal year. This further reduces the extent of support the rupee could have received from expectations of rising interest rate differentials vis-a-vis the US rates and a pick-up in capital inflows. The rupee-dollar pair could trade in the range of 46.40 - 47.00 this week.

(The writer is senior economist, ABN Amro Bank. Views  are personal)