Bullish sentiment may be on the wane

Risk aversion, oil and a possible greenback recovery are major triggers

Risk aversion clouded bullish sentiments across the globe last week, as the crisis in the financial sector related to the US sub-prime mortgages and credit markets showed signs of deepening.

Fears of inflation flaring up on the back of record-high commodity prices, particularly crude oil, further dented the fragile sentiment.

As a result, the equities market, especially in the developed economies finished their worst week in recent months.

Investors rushing towards safety saw large unwinding of carry trades. Such market backdrop was negative for high-yielding currencies and beneficial for low-yielders, particularly the Japanese yen.

Locally also equity markets slid over the week on global cues.

The Sensex fell by 5.3% during the week as FIIs turned net sellers of Indian equities and bonds and withdrew $351.6 million. International crude oil prices also hovered above $95 per barrel and the price of the Indian crude oil basket climbed above $90 for the first time. Thus the market sentiment towards the rupee was a little cautious.

Capital inflows from sources other than portfolio investments were quiet strong and that supported the Indian unit. Exporters also sold dollars when the rupee weakened towards the end of the week.

Intervention by the RBI, however, ensured that the supply of dollars matched the demand for them. The rupee finished the week almost flat in a week when the trading volumes were thin.

The rupee-dollar pair traded in a narrow range of 39.185 - 39.39 over the week. 

In the rupee-dollar forwards market, fears of tightening rupee liquidity and sell (spot)-buy (forward) swaps by the RBI pushed up the forward premiums. Premiums in the near tenors, up to two months, went up the most during last week.

In the international market, the US dollar underperformed its other major currency peers yet again. The greenback remained under pressure due to heightenedexpectations of another Fed rate cut.

However, the US dollar was sold heavily on Wednesday after a Chinese politician commented that the Chinese central bank should diversify into stronger currencies to counter the impact of weakness of the greenback on the country’s $1,430 billion foreign exchange reserves.

Ben Bernanke, Fed chairman, speaking on Thursday to the Congressional Joint Economic Committee, raised expectations of further near-term rate cuts.

He expressed heightened concerns that weakness facing the financial and housing markets could hurt US economic growth.

Although inflation was still a concern, Bernanke said growth would slow “markedly” this quarter and would remain “sluggish” during early 2008. The futures market is now pricing in a 0.25% rate cut in December with full certainty.

On the same day, the European Central Bank (ECB) president, Jean-Claude Trichet, made it clear that the ECB would not cut rates any time soon, as the bank was still concerned over inflation.

The euro gained 1.2% against the greenback over the week, having reached a new record of $1.4752 on Friday.

The Bank of England also resisted calls to lower its policy rate on Thursday, holding it at 5.75%, amid continued worries about high inflation.

Sterling rose marginally over the week, after having hit a 26-year peak of $2.1161 on Friday.

The sense of panic caused by tumbling global stock markets, proved to be most beneficial for the yen, which has been the main funding currency for carry trades.

All the key high-yielding currencies finished lower against the yen.

The Australian dollar was down 2.6%, even though the currency was supported a 0.25% increase in Australian interest rates to 6.75%. The New Zealand dollar was off 3.4% over the week, while the Pound fell 1.6% and the euro dipped by 0.6%.

This week local market participants could remain cautious about the near-term prospects of the rupee.

Record high crude oil prices and a mood of risk aversion could put some pressure on the Indian unit, by raising the demand for greenbacks.

Also, the RBI’s ability to buy dollars while keeping a check on excess rupee liquidity got bolstered last week.

The government raised the limit on outstanding market stabilisation bonds to Rs 2,50,000 crore from Rs 2,00,000 crore. 

Hence it is clear that the central bank and the government want to stem the pace of rupee appreciation.

Other than these factors, a raft of key US data releases this week also hold a lot of significance for the local market. October data for US retail sales (a gauge of consumer spending), inflation (consumer and producer prices) and net capital inflows are due this week.

If inflation surprises on the upside, which is quiet possible, then the chances of near-term rate cut would be lowered.

A stronger-than-expected reading of retail sales will further help in pricing out a rate cut. Thus the greenback will clearly gain from stronger data. Even market positioning with short dollar bets at their highest, could arrest the dollar slide for a while.

Considering these downward pressures and risks, the rupee-dollar pair could trade in the range of 39.20 - 39.70 this week, with a mild depreciation bias.

Upward pressure on interest rates, on the back of the CRR hike and a positive outlook on capital inflows would continue to provide support to the rupee. 
 
The author is senior economist, ABN Amro Bank. Views expressed herein are personal. E-mail: gaurav.kapur@in.abnamro.com