Comment

Financial markets were relatively calm last week but the sentiment of risk aversion prevailed. The focus for most of the week was on the rescue package for debt-mired Greece by the European Union.

The leaders of the 16-country eurozone stopped short of providing immediate financial support for Greece, but gave an implicit assurance to help Athens if it encountered problems in refinancing its sovereign debt later this year. This assurance helped create some appetite for riskier assets. On Friday however, a surprise move by the People’s Bank of China (PBOC) to further tighten its monetary levers prompted a flight from riskier assets to the safety of the US dollar-denominated assets.The PBOC raised its cash reserve requirements for commercial banks by 0.5%, raising fears of rapid monetary tightening by the Chinese central bank.
In the currency market, the euro continued to suffer as market participants remained concerned over Greece’s fiscal deficit position.

The European Union was unable to convince the financial markets that the crisis was over, partly because of a lack of detail over what a rescue package would entail. On Friday, the Euro fell to its weakest level since May 2009 against the US dollar, before recovering some ground. The single currency ended the week down 0.3% against the greenback.

The euro’s losses were compounded by news that the eurozone’s economic recovery faltered late last year. Figures showed that the eurozone GDP rose just 0.1% in the fourth quarter of 2009, below consensus forecasts.

The other European major, the pound fell early in the week against the US dollar after the Bank of England cut its forecast for economic growth and said that inflation would undershoot its 2% target significantly if interest rates rose as fast as markets forecast. Sterling later regained some of its losses to stand 0.4% stronger on the week. Sterling also rose against the euro, rising 0.7% over the week.

The dollar index, which tracks the greenback’s value against a basket of six leading currencies, hit a seven-month high of 80.539 on Friday, before giving back some of its gains to stand flat at 80.380 on the week.

Improved risk appetite helped commodity-linked currencies. The Australian dollar fell on the news of Chinese tightening, but it was up 2.3% on the week after better-than-expected employment data on Thursday and a rise in risk appetite caused by bailout hopes for Greece. The jobs figures increased expectations that the Reserve Bank of Australia would raise interest rates next month, after having surprised investors by keeping them on hold at its February meeting.Currencies of other commodity exporters also advanced, with the New Zealand dollar 0.8% higher on the week, the Norwegian krone adding 1.2% and the Canadian dollar rising 1.3%.

The Swedish krona rose 2.8% on the week to hit a 15-month high against the Euro. The Krona’s advance followed the Swedish central bank’s decision to leave interest rates on hold after its policy meeting on Thursday, though it signalled it would tighten its monetary policy by the summer or early autumn, sooner than the market had expected. The Krona rose 2.4% against the US dollar on the week.

In the local market, the rupee recovered some of the ground it has lost to the US dollar in recent weeks. The Indian unit appreciated by 0.6% over the week against the greenback, helped by the stock market finishing in the positive territory after many weeks. Dollar-selling by exporters also helped the rupee gain ground. Over the week, the rupee-dollar pair traded in the range of 46.37-46.865.

Going by the reaction to the news of Chinese monetary tightening, financial markets are likely to start this week with a low risk appetite. Strong bouts of financial market risk aversion tend to lead to substantive US dollar rallies, and it remains critical to watch risk trends. For that purpose, market participants would watch for any surprises in US economic events due this week.

Key events will start with Wednesday’s release of minutes from the most recent Federal Open Market Committee rate decision and will be followed by Thursday’ producer and consumer price index reports. All three events can create shifts in market interest rate expectations and, by extension, the dollar.

Market participants would look for hints as to when the US Federal Reserve might begin raising interest rates in 2010, while any especially large surprises in PPI and CPI could likewise offer clues on the trajectory of Fed rates. Fed chairman Ben Bernanke recently outlined the steps the US central bank could take to begin withdrawing massive monetary policy stimulus in an address to the US legislature. When these plans can be put into action depends on the pace of economic recovery in the US and trends in employment and inflation.

Recent disappointments in employment data would imply that the Fed is in no hurry to tighten monetary conditions. However, if the Fed meeting minutes show any willingness to tighten rates through the coming months or there are any substantive surprises in PPI and CPI data, the US dollar could rise. Interest rate derivatives show markets foresee zero probability that the Fed will raise interest rates in the coming months. Any signs that rate hikes could come sooner could severely risk sentiment.
In the local market, the rupee is likely to fall on Monday as the stock market is likely to react negatively to the news of Chinese monetary tightening. And, with risk aversion prevailing in the financial markets, the prospects of an improvement in portfolio capital inflows also remain weak.On fundamental grounds, rapidly improving growth conditions, as was evident in the strongest industrial production reading in 20 years, continue to provide support for rupee strength in the medium term. But other cyclical problems, especially rising inflation could dampen the market sentiment. Overall, the rupee-dollar pair could trade in the range of 46.25-47 this week.

The writer is senior economist, ABN Amro Bank. Views expressed herein are personal.
E-mail: gaurav.kapur@in.abnamro.com