Comment

Risk environment improved last week pushing US and European equities to their highest levels in 2009. The main trigger behind the global stock market rally was much stronger than expected US corporate earnings. With just over one-third of S&P 500 companies having reported second-quarter earnings, about three-quarters of them exceeded expectations. Relief that majority of corporate earnings reports surprised positively helped maintain recent upward momentum.

Tentative signs of stabilisation in the US housing and labour markets and positive economic data elsewhere, along with fading concerns about the possibility of systemic failure, as US corporate lender CIT Group managed to avoid bankruptcy for now, added to the bullish mood among market participants.

A cautiously optimistic testimony from Ben Bernanke, chairman of the US Federal Reserve, before the US Congress and relatively upbeat assessments from other central banks, including the Bank of England and the Bank of Canada, also helped in reinforcing optimistic sentiment.

The yen and the US dollar suffered as an improvement in risk appetite weighed on safe-haven demand for both currencies as investors searched for yield. The yen was also undermined by signs that Japanese retail investors were increasing demand for overseas assets.

An estimated ¥700 billion ($7.4 billion) of Toshin funds, which allow Japanese retail investors to invest in higher-yielding currencies, were offered to the public. These funds were mainly targeted at assets denominated in the Australian dollar, the Brazilian real, the South African rand and the Turkish lira.

Over the week, the yen lost 0.6% against the US dollar, fell 1.4% against the euro and dropped 1.3% against the pound. The yen’s losses were more acute against commodity-linked currencies. Over the week, it fell 2.5% against the Australian dollar, dropped 2.6% versus the New Zealand dollar and lost 3.9% against the Canadian dollar.

The greenback also suffered losses, falling 0.8% against the euro over the week, losing 0.4% against the Swiss franc and dropping 0.6% against the pound.

Increased investor optimism also boosted emerging market currencies. The Turkish lira rose to a fresh high for the year against the US dollar, climbing 2.6% over the week, while the South African rand rose 4% and the Brazilian real gained 1.6%.

In the local inter-bank market, the rupee also appreciated by about 1% against the US dollar on the back strong equity markets and continuing inflow of portfolio capital. The stock markets were boosted by Indian corporate earnings surprising on the upside and as FIIs increased their holdings of local bonds and equities.
Last week, net purchases by the FIIs amounted to $357 million.

Over the week, the rupee-dollar pair traded in the range of 48.18 – 48.61. The Indian unit’s gains were curtailed by demand for dollars from importers and other corporates.

Looking ahead to this week, the most immediate threat to the greenback’s stability is the intensity and direction of risk appetite.

With the US Federal Reserve looking to keep the benchmark lending rate at levels that insure a carry status for greenback when conditions do turn around, and high fiscal deficit ensuring that the US economy will struggle with record levels of debt for years to come, the US dollar would most likely maintain its position as the opposite of risk appetite. The primary source of momentum for risk appetite this past week — the second quarter earnings season — is on the decline with most results now known. One of the most likely catalysts for risk going forward is the most attention grabbing indicator on the US data calendar — the GDP data which is due for release on Friday.

The US GDP data is also critical for market participants all over the world because it is a gauge of global growth.According to consensus forecasts, the world’s largest economy contracted at a 1.5% on an annualised basis through the second quarter of 2009.

This would be a marked improvement from the 5.5% and 6.3% rate of the recession through the first quarter of 2009 and fourth quarter of 2008, respectively. If the reading is better-than-expected, the positive influence on risk appetite could outweigh the implications for US returns and actually drag the greenback down and vice-versa.

In the local market this week, the focus initially will be on the quarterly monetary policy review announcement by the RBI on Tuesday.Market at large expects the central bank to keep its policy rates unchanged.

However, there is a possibility of a 25 bps rate cut to support the economy facing deficient monsoons and in order to keep interest rates from rising in the face of a record market borrowings by the central government.

A surprise rate cut would be positive for the equities market and thus for the rupee. Other than the rate action, RBI’s assessment of the strength of the economic recovery would also be crucial and so will be any discussion on the withdrawal of excess liquidity in the financial system. Any optimism on the part of the central bank on the growth front would be positive.

Towards the end of the week, focus would shift towards US GDP data and the global investor risk appetite and the greenback’s position against other major currencies would become the main drivers of the price action.

The US dollar could come under pressure this week too and that would be positive for the rupee. Overall the rupee-dollar pair can trade in the range of 47.75 – 48.50.

Forward view
A possible 25 bps rate cut by the RBI could be positive for the rupee and the stock markets.

Any optimism on the part of the central bank on the growth front would be positive.

Overall the rupee-$ pair can trade in the 47.75-48.5 range.

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