Rupee may remain under pressure as market conditions support US dollar

Concerns about global growth and Eurozone sovereign debt cast a shadow over the financial markets last week. A series of disappointing US economic releases provided the most notable signs of slowdown.

Markets were also rattled by a weak reading of German investor confidence. Confirmation that Japan had slipped back into recession in the first quarter, highlighted the potential for earthquake-related supply chain disruption to impact on the global economy. Heightened risk aversion saw US Treasury yields fall to a 2011 low while fears of debt restructuring sent Greek bond yields to a record high. Equity and commodity prices came under pressure too.

In the global currency markets, sterling and the euro took diverging paths last week as the outlook for interest rates in the UK and the Eurozone assumed more clarity.

Inflation in the UK was shown on Tuesday to have hit its highest annual rate since 2008 in April at 4.5%, up from 4% in March. Sterling rallied in the immediate aftermath, with market participants thinking that the Bank of England (BoE) would be forced to lift the UK’s key interest rates from their historic low of 0.5% by at least 0.25% before the end of the year.

On Wednesday, though, minutes from the BoE’s May monetary policy committee meeting showed 6-3 split in favour of holding rates. Moreover, Mervyn King, the BoE governor, has maintained throughout the current wave of inflation rises that price pressures would drop towards the end of the year as value added tax (VAT) increases and higher commodity prices damp demand.

Over the week, the sterling was 0.2% higher against the greenback. Eurozone debt concerns drove a late surge in safe haven buying of the US dollar on Friday.

Rating agency Fitch downgraded its long-term sovereign debt rating on Greece from BB plus to B plus, and put the country on “rating watch negative”.

This overshadowed Monday’s data showing Eurozone CPI rose to 2.8% in April, from 2.7% in March. The euro remained 0.2% higher over the week against the greenback, in spite of a 1% fall on Friday as Eurozone debt concerns came to the fore. The single currency finished the week unchanged against the pound.

The yen was one of the week’s big casualties after the news that the Japanese economy had contracted for a second successive month, signaling recession. Latest GDP growth data released on Thursday showed that the Japanese economy slipped into its third recession in a decade. The Japanese yen lost 1.1% against the US dollar over the week and was 1.4% weaker against the euro. The yen fell 1.3% versus the pound.

In the local market, the rupee remained on losing ground against the greenback. The Indian unit weakened in the first half of the week as the US dollar gained overseas and stock market dwindled lower. The rupee-dollar pair crossed the 45 level on Monday. During the second half of the week, some dollar selling emerged from exporters which helped the rupee gain some lost ground. Over the week, however, rupee finished weaker against the greenback and the rupee-dollar pair traded in the range of 44.885-45.175. In the week ahead, as the end of the QE2 programme of the US Federal Reserve draws closer, a US dollar-supportive theme is emerging. The Fed’s final bond purchase of $6-8 billion in Treasuries is slated for June 9, which is only three weeks away. That hints at rising urgency to unwind greenback-funded carry trades across the spectrum of assets before borrowing costs creep higher.

Last week, market participants pared some of their recently-accumulated greenback exposure ahead of the release of minutes from the recent Fed monetary policy meeting where the programme’s expiration date was set in stone. The takeaway from that publication proved a bit more hawkish than expected. Most of the major points mirrored Ben Bernanke’s inaugural quarterly press conference in April — the Fed will allow QE2 to expire in June and rate hikes may be undertaken while unemployment remains high if inflation expectations gain traction.

The unanimous consent among the policy makers to gradually reduce the size of the Fed balance sheet over time and increasingly vocal concerns about the “upside risk to the inflation outlook” have all reinforced expectations of rising US yields in the second half of the year.

That combined with an upward revision to first-quarter GDP data, putting the annualised growth rate at 2.2% versus the previously reported 1.8% growth promises to reinforce the trajectory of rising US rates. Any signs of strength in the US economy will tip the scales in favour of expectations of faster monetary policy normalisation and provide support to the US dollar.

Otherwise, a week of relatively limited economic event risk leaves market focus squarely on developments surrounding Greece and broader financial market trends. Norway’s decision to suspend financial aid to Greece has little tangible effect on sizeable budget deficits, but the psychological effect is clear as market participants fear anti-bailout sentiment will prompt similar moves from other Eurozone nations.

In the local market, rupee can remain under pressure as global market conditions support the US dollar and keep a check on risk appetite. Stock markets remain in a largely bearish mode which is not supportive for the rupee. Moreover, with the month drawing to a close, the regular month-end related demand for dollars will emerge adding to the pressure on the rupee. The rupee-dollar pair can trade in the range of 44.75 - 45.50 over this week.

The writer is senior economist, Royal Bank of Scotland NV, and can be reached at gaurav.kapur@rbs.com. Views are personal.