Growing market confidence, dollar weakness could boost Re

Global financial markets continue to be driven by improving risk appetites on rising optimism about the world economy.

Last week, the key event market participants were waiting for — the meeting of the heads of state of the G-20 group of nations — sent positive signals to the market. The foremost among the decisions taken at the London G-20 summit was the commitment to raise the funds available to the International Monetary Fund (IMF) by $1 trillion to fight the global financial crisis.

That, along with signs that the worst of the economic downturn may have passed, helped improve investor confidence and stoke the appetite for risk. Risk-taking market participants pushed up equities, commodities and emerging markets. In the currency market, the US dollar and the Japanese yen retreated last week.

Early signs of stabilisation in the world economy were visible last week. The manufacturing sector, purchasing managers’ indices (PMI)from the US, the UK and China for March beat expectations.

Although still suggesting a contraction in activity in these countries, the improvement over the previous month raised hopes that aggressive fiscal and monetary loosening across the world was beginning to filter through to the global economy. This improvement in a key leading indicator of activity boosted stock markets worldwide, lessening safe haven demand for the greenback and the yen.

The unexpected increase in IMF funds proved to be a pleasant surprise, giving rise to the view that a new “London consensus” showed that industrialised nations wanted to prevent a growing crisis in emerging markets. Currencies in emerging markets performed strongly as a result. The Brazilian real rose to 3.2% against the US dollar over the week, the South African rand climbed 4.5% and the South Korean won gained 0.6%.

Central and eastern European currencies, which have fallen to multi-year lows as the financial crisis raised fears over the ability of countries in the region to finance their deficits, also performed strongly. The Hungarian forint rose 4.1% against the US dollar over the week, while the Polish zloty climbed 5.5%. Currencies of commodity-producing countries rose, with the Australian dollar rising 3.1% against the greenback on the week and the New Zealand dollar climbing 2.7%.

The US dollar fell 1.4% against the euro over the week, with the single currency receiving additional support from the European Central Bank’s decision to cut interest rates by less than expected on Thursday. The ECB lowered its main lending rate by 0.25% to 1.25%, against expectations of a 0.50% cut. The greenback fell 3.5% against the pound over the week and dropped 1.2% against the Swiss franc.

The greenback did advance against the yen, however, briefly breaching the 100 level for the first time in five months. The rise in risk appetite seemed to have renewed interest in carry trades and encouraged Japanese investors to pour money abroad. Over the week, the yen fell 2.5% against the US dollar, lost 3.9% against the euro and dropped 6.1% against the pound.

In the local inter-bank market, the Indian rupee also appreciated by over 1% against the US dollar last week. Rupee started the new fiscal on a firmer footing, after depreciating by over 26% against the greenback in the last fiscal.

Last week, the rupee was helped by the greenback’s general weakness along with a rally in the equities market. Market sentiment was also boosted by the ABN Amro India manufacturing PMI reading of 49.5, which indicated that the business activity could just be stagnant and not contracting anymore. Over the week, the rupee-dollar pair traded in the range of 50.11-51.32.

A slew of data, especially from the external sector, was released last week. The foremost of them was the Balance of Payments (BOP) which recorded a $17.9 billion deficit for the December 2008 quarter. The quarter saw a record current account deficit of $14.7 billion and capital account deficit of $3.7 billion. This was the worst quarter in terms of capital inflows, since the quarter ended September 1998.

The merchandise trade data for February 2009, however, showed that some improvement on the trade deficit front occurred in the next quarter. Exports fell by 21.7% year-on-year (y-o-y), posting contraction for the fifth consecutive month. Contraction in imports also extended for the second successive month led by the plunge in oil imports. Imports fell by 23.3% y-o-y — the largest fall since February 2001.

That helped lower the overall trade deficit to $4.9 billion from $6.1 billion in January. On the whole, it appears that while there has been some improvement in the BOP situation in 2009 on the back of lower oil prices, the external fundamentals remain weak.

Going forward, any shifts in the risk-taking patterns will be the key to the action in financial markets, especially the currency markets. Post the G-20 consensus to restore global growth and clean up the financial services industry, risk aversion could diminish for some time at least. That in turn would reduce the safe haven demand for the US dollar and the Japanese yen.

However, to sustain this newfound confidence, market participants would look to a quick implementation of the “London consensus”.
Data releases in such an environment will also play a crucial role. Any improvement, especially in the data from the US, is likely to boost investor confidence in riskier asset classes.

This week, the release of minutes of the Federal Reserve’s rate setting committee FOMC’s March meeting, will therefore be crucial. Any revisions in the FOMC’s long-run projections for growth, unemployment, and inflation that indicate that the outlook is even worse than previously anticipated, could hurt risk appetite and lift safe-haven currencies like the US dollar.

In the local market, rupee could regain some the ground lost to the US dollar, helped by favourable global market conditions. However, rupee’s gains, if any, would be limited, given that a pick-up in commodity prices, especially oil, would worsen the trade deficit situation. This week, the rupee-dollar pair could trade in the range of 49.75-50.50.