Rising risk appetite could keep the Re supported

Fears over the Dubai World debt standstill have been allayed. Investor risk appetite is improving. Market participants got some respite last week from the Dubai debt crisis after the central bank in UAE stepped in to provide a liquidity support window to contain the damage. Risk appetite improved as apprehensions over the possible contagion from the Dubai debt problems eased.

In the currency markets, a recovery in risk appetite and heightened concerns from Japanese authorities over the strength of the Japanese yen pulled the currency back from a 14-year peak against the US dollar last week.

Week before last, Dubai’s debt problems had prompted investors to liquidate carry trades. That had pushed the yen up to the 14-year high against the US dollar on November 27. But as risk appetite improved and worries over Dubai debt crisis faded, investors re-entered carry trades funded using the yen and pushed the Japanese currency lower.

The move was given impetus by Friday’s US employment report, which came in stronger than expected, lifting investor confidence over the prospects for global growth. 

Pressure on the yen also intensified as Japanese government officials became increasingly vocal on the issue of currency strength, given its potential to derail their efforts to fight deflation and economic recovery. A strengthening currency helps counter inflationary pressures emanating from costlier imports.  

The Bank of Japan (BOJ) undermined the yen on Tuesday by announcing measures to pump more liquidity into the banking system after an emergency monetary policy meeting. Described by the Japanese central bank as quantitative easing in a “broad sense”, the BOJ announced a new three-month loan facility offering Y10000 billion in term financing to commercial banks.

Meanwhile, in a pointed remark on Wednesday, Japan’s Prime Minister Yukio Hatoyama, said the yen’s strength could not be “left as it is”. The message coming from the Japanese government regarding the yen is an indication of political consensus that the currency is too strong. Over the week, the yen fell 4.7% against the US dollar, lost 3.9% against the Euro and dropped 4.5% against the pound.

The yen fell more sharply against the Australian dollar, sliding 5.7% on the week as the Reserve Bank of Australia delivered a third consecutive rise in interest rates after its monthly policy meeting, lifting its main lending rate by 0.25% to 3.75%.

The US dollar, which like the yen has been widely used as a funding currency in carry trades, rallied after Friday’s unexpectedly strong US employment report. The non-farm payroll (NFP) report on Friday surprisingly showed that the US labour market only lost 11,000 jobs in November, compared with consensus forecasts for a decline of 125,000.

Importantly, this was the best reading since December 2007, suggesting the labour markets may be nearing a turning point. The greenback rallied as investors focused on the potential for the US economy to recover more quickly than expected. The implication of that would be for the Federal Reserve to exit from its ultra-loose monetary policy stance sooner than forecast.

The Fed funds future showed investors now expect the central bank to raise interest rates by 25-50 basis points in August 2010, rather than September. Over the week, the US dollar rose 0.8% against the euro, climbed 1.1% against the Swiss franc and gained 0.1% against the pound.

In the local market, rupee appreciated 0.8% against the US dollar last week. The Indian unit was helped by a rally in the equity market and continuing portfolio capital inflows.

The greenback’s weakness in the overseas market during the first few days of the week also helped the rupee. Stronger-than-expected second-quarter real GDP growth also boosted the local currency as it brightened the outlook for foreign capital inflows. FIIs bought over $1 billion worth of Indian equities and bonds last week. Overall, the rupee traded in the range of 46.065 - 46.535.

This week, crucial data points include the US retail sales data for the month of November. On Friday, the US Commerce Department is forecasted to report that US retail sales rose 0.6% in November, after rising 1.4% in October on the back of auto sales.

Likewise, the retail sales index excluding autos is projected to increase 0.5%. The upcoming advance retail sales report could reflect rising consumption trends through the end of the year. If the US dollar returns to trading in line with risk trends, positive results on the retail sales data could weigh on the currency.

In the local market, rupee can continue to trade with some appreciation bias on the back of improved risk appetite. But any appreciation in the Indian unit would be limited due to the fact that with the year-end approaching, portfolio inflows would slow down.

Moreover, with the equities market seeming to have topped out for the moment, there is unlikely to be any sharp move in the rupee-dollar pair. It also remains to be seen how Asian stock markets react to the improvement in the US jobs data. Any recovery in the greenback post the NFP data would also weigh on the rupee.

A more encouraging piece of data for the rupee was the merchandise trade data for October, which was released last week. While exports continue to contract, the pace of decline has been falling over the last few months and as a result, the trade deficit came down again in October.

If this trend of improving external demand persists, it would certainly be helpful for the rupee. Over the coming week, rupee-dollar pair could continue to trade in the range of 45.80 - 46.50.

The writer is senior economist, ABN Amro Bank, and can be reached at gaurav.kapur@in.abnamro.com. Views  are personal.