Comment

The rally in the US dollar continued last week. The greenback rose to a three-month high on a trade-weighted basis as investors took profits on bets against the greenback ahead of the year-end. The US dollar, which has risen almost 5% since hitting a 16-month trade-weighted low at the end of last month, continued to be driven by heightened expectations that the US Federal Reserve would exit from its ultra-loose monetary policy stance sooner-than-expected. This view has been stoked by a string of better-than-expected US economic data during the past month.

The Fed also delivered a modest upgrade to its assessment of the US economy after its policy meeting on Wednesday. However, the central bank also maintained its pledge to keep US interest rates at ultra-low levels for an extended period. The dollar index rose to a three-month high of 77.94 on Thursday, before giving back some of its gains on Friday to stand up 1.7% at 77.856 over the week.

The greenback rose 1.9% to a three-month high against the euro as fears over the health of the Eurozone banking sector and concerns over the fiscal position of some countries on the periphery of the Eurozone continued to weigh on the single currency. Those concerns were heightened as Austria nationalised HGAA, its sixth-largest bank by assets, and Standard & Poor’s downgraded Greece’s sovereign debt. Over the week, the euro also fell 1.3% against the Pound.

The US dollar also advanced against the Japanese yen, rising 1.4% during the week, as the Bank of Japan made an addition to its statement following its policy meeting on Friday, saying it would not tolerate consumer price inflation below zero. This addition was interpreted as a tougher stance on deflation. Such a stance, if followed by action, should push Japanese government bond yields lower and have negative implications for the yen.
The greenback rose 0.7% to a two-month high against the Pound and gained 0.7% to a three-month high against the Swiss franc. The Australian dollar dropped 2.4% as Australian growth data came in below expectations.

In the local market too, the rupee traded with a downward bias against the US dollar last week. The news of Dubai World bail out and Moody’s upgrade of outlook of Indian local debt rating did little to shore up market sentiment. Equity markets declined over the week and oil prices rose, both of which were negative for the rupee. Greenback’s continuing strong run was, however, the main dampener for the Indian unit. Some dollar selling emerged as the rupee-dollar pair came close to the level of 47.00. Over the week, rupee-dollar pair traded in the range of 46.57 - 46.96, depreciating 0.4%.

We are heading into a highly reactive period in the markets and nascent trends can quickly reverse or get amplified depending on the prevalent conditions. With most of the Western world shut for the Christmas holidays over the next few weeks, market liquidity will be thin and will remain depressed until after the turn of the year. Under such conditions, markets normally stabilise and volatility is dampened, but there have also been instances when the leveraged influence of speculators has amplified price action and setoff meaningful breakouts.

Considering the aggressive move the greenback has made over the past three weeks, the currency is working with considerable momentum. Extending or retracing this move depends on speculative interest.

Given this backdrop, there are a few prominent drivers that should be monitored. Interest rate speculation has been a major contributor to the US dollar’s strength so far and the consensus forecast is for a rate hike by June 2010.

The benchmark US market rate (the three-month Libor) is still edging towards record lows, but its pace has slowed. Record low interest rates have contributed to the greenback’s woes this year as investors have moved from diversifying safe-haven assets to using the US dollar to fund the re-emergent carry trade.

The economic release calendar is full of notable US data releases that can stoke volatility during the thin liquidity conditions. The key data releases next week are the personal spending and income data for it updates on the state of US consumers.

In the local market, price action would depend on the US dollar’s strength. With liquidity thinning out towards the end of the year, rupee could continue to trade with a weakening bias. The momentum is clearly against the local equities market and that is clearly negative for the rupee. And, with oil prices rising now on the back of improving demand, it too could add to the pressure on the Indian unit. Portfolio inflows are also slowing down and foreign institutional investors were net sellers last week. A significant development for the rupee is improving exports, seen in the first positive growth number in over a year for the merchandise exports in November. The rupee-dollar pair can trade in the range of 46.40 - 47.00 during this week.

(The writer is Senior Economist, ABN AMRO Bank. Views expressed are personal)