Forex review: Market momentum in favour of rupee

In the financial markets last week, growing confidence in the global recovery pushed up equities, emerging market assets and higher-yielding currencies at the expense of government bonds and the Japanese yen. The markets held up in the face of a deteriorating picture on peripheral eurozone sovereign debt. Signs of a meaningful improvement in the US labour market added to the confidence.

The US non-farm payrolls rose by 216,000 last month, more than expected, while the unemployment rate eased to 8.8% from 8.9%. The jobs data, along with an encouraging reading on the US Institute for Supply Management’s index of manufacturing activity, came along side a series of hawkish comments by Federal Reserve officials that focused attention on the withdrawal of monetary accommodation.

Expectations increased that the US Federal Reserve might abandon its ultra-loose monetary policy stance. The interest rate futures market moved to price in a 43% chance that the Fed will raise its target rate in December, compared with 35 % on Thursday.

Meanwhile, expectations that the European Central Bank (ECB) would raise rates at its policy meeting next week were bolstered by surprisingly robust eurozone inflation figures.

In the currency markets, the Japanese yen dropped to a six-month low against the US dollar last week and a 10-month trough against the euro as expectations heightened that other major economies were set to tighten monetary policy. Widening interest rate differentials and the prospects that Bank of Japan has drawn a line over yen’s strength by its market intervention efforts last month, encouraged market participants to get into yen- funded carry trades.

The yen fell 3.4% against the greenback during the week, its weakest level since September. It also dropped 3.8% against the pound over the week and fell 4.4% to a 10-month low against the euro.

The single currency remained resilient, shrugging off renewed concerns about the fiscal health of countries on the periphery of the eurozone to focus on the prospect of monetary tightening in the region. The euro was supported after an unexpected rise in eurozone inflation. That cemented expectations that the ECB would deliver a 0.25% interest rate increase at its policy meeting on April 7, taking its main lending rate to 1.25%. The euro climbed 1% against the US dollar over the week and rose 0.6% to a five-month high against the pound.

The Australian dollar, which due to its relatively high yield has been a favourite target currency for carry trades, hit a record high against the US dollar and climbed 4.7% against the yen over the week.

In the local market, rupee continued to gain against the US dollar. Rising local stock market and a pick-up in FII inflows also bolstered the rupee. Inflows of FIIs into local stocks and bonds amounted to $634.6 million last week. Changes and rationalisation of the FDI norms, announced by the government last week, also helped the rupee. Over the week, the rupee-dollar pair traded in the range of 44.505 - 44.90 and the Indian unit appreciated by 0.2%. The gains were muted by month-end demand for dollars by corporates, especially oil companies.

Going forward, there are two primary concerns when it comes to the US dollar — underlying risk appetite trends and relative interest rate expectations. The improvement seen in the US labour market over recent months may not translate into strong gains for the greenback just yet as the improvement seen in the context of the recession is still modest. Moreover with labour market trends strengthening corporate earnings and growth expectations, the resultant bolstering of the risk appetite would lift risky assets such as equities and subsequently weigh on the ‘safe haven’ US dollar.

The balance between risk and reward remains the greenback’s primary hurdle. Demand for return is keeping capital moving towards riskier assets such as emerging market bonds, high beta stocks, commodities and high market rates. However, moving forward there is just as much potential that yield differential swings back in favour of the US dollar. The past two weeks has shown us a clear hawkish lean from the Fed. Moving forward, market participants will closely follow what the Fed officials have to say about the quantitative easing and the general monetary conditions in the US. In the coming week, the greenback may also gain if the ECB after hiking rates signals a gradual path to monetary policy tightening in the eurozone. If that happens, market participants will be forced to reassess the situation around the eurozone sovereign debt, which has been deteriorating.

In the local market, rupee has appreciated to a 4-month high against the US dollar on the back a weakening greenback overseas, rallying stock market and a pick-up in capital inflows into India, especially portfolio inflows. The rupee-dollar pair touched a crucial technical level of 44.50 last week, but did not break it.

Market participants are aware that any further sustained appreciation of the rupee is dependent on global crude oil prices and the strength of the US dollar. Over the last couple of months trade deficit has stabilised at $8 billion a month despite a sharp increase in oil prices, helped by strong exports growth. Even the latest balance of payments data for the last quarter of 2011 showed improvement in the overall current account deficit helped by improving software exports and other invisible flows. However, this improvement may not be sustainable, as oil prices could remain well above $100 per barrel, while exports growth momentum may slow down. Going ahead, while the market momentum remains in favour of the rupee, further appreciation potential remains limited in the face of high global crude oil prices.

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