Flight to safety, $ rally remain the key trends

Financial markets were gripped by panic and risk aversion after the US Federal Reserve indicated that it saw “significant downside risks” to the US economy and Greece struggled to avoid default, spurring a flight to safety. Adding to market concerns, the IMF sharply downgraded its growth forecasts for the developed economies. A pledge of support for the global economy by the G20 nations failed to spark a significant reversal in riskier assets, with global investor sentiment still extremely fragile on worries about the economic outlook and the Euro-zone sovereign debt crisis.

Risk aversion in equity and commodities markets drove the US dollar higher last week as hopes for economic recovery were dealt another blow by the Federal Reserve’s latest assessment of US growth. The IMF also said the US economy will expand 1.5% this year, down from the 2.5% projected in June, citing unresolved debt-reduction concerns and waning confidence among consumers and businesses.

The greenback climbed across the board on Thursday as market participants sought safety and global equity markets tumbled with other risk assets, including industrial metals and oil. The latest catalyst for investors to flee for cover was the Fed’s statement on Wednesday that there were now “significant downside risks to the economic outlook.”

Although the Fed delivered, as expected, its ‘Operation Twist’ monetary easing measures, they had already been broadly priced in to asset markets, and it was the bleak economic appraisal that shored up demand for the US dollar, and with it the Japanese yen.

The euro, pound and riskier currencies rallied modestly on Friday after G20 finance chiefs issued a communiqué pledging action to tackle the global economic crisis. However, the prevailing sentiment of risk aversion remained. Over the week, the euro fell 2.1% against the dollar, while the pound lost 2.2%. The euro fell 2.4% against the yen, while the pound lost 2.4%. The euro was flat against the pound, while the yen climbed 0.2% versus the greenback.

Central banks of emerging market economies intervened to stem the decline of their currencies amid growing concerns about a global slowdown. Two central banks last week were seen selling dollars to support their own currencies. After sharp losses on Thursday, South Korea’s monetary authorities were suspected of heavy intervention to try to prevent a disorderly decline in the won.

The country’s central bank was estimated to have sold $1-2 billion on foreign exchanges on Friday, pushing the won 1.3% higher on the day. The currency, however, was down 4.7% versus the dollar over the week.

Brazil’s central bank on Thursday said it would sell $2.75 billion in currency swaps, which helped prop up the Brazilian real. On Friday, the real traded 1.3% higher versus the greenback, but remained 8.4% lower on the week.

In the local market, the rupee also depreciated 4.6% against the dollar, as global investor risk aversion saw market participants going long on dollars sharply increasing the demand for greenbacks. FII investors remained net sellers of local bonds and stocks. Over the week, the rupee-dollar pair traded in the range of 47.43-49.89 and the rupee touched a two-year low against the US dollar. There was some speculation that the RBI intervened in the market to provide some support to the rupee and reiterated that it was monitoring rupee movements closely.

Risk aversion has once against overrun the markets but the current situation is different than what we were seeing back in July/ August. What we are seeing now is more fundamentally rooted. And, what makes it much more extraordinary is that panic is setting in at the same time that we are testing the boundaries of policy stimulus. For the dollar, these are ideal conditions.

If we were to look at the list of traits which helps a currency appreciate, it is quite clear that the greenback is severely lacking. For the dollar, interest rates are near-zero and will likely remain there for a few years, economic activity is clearly slowing and its prized safe haven status is under constant pressure. Under normal circumstances, when the broader markets are stable or expanding these problems would undermine the greenback’s appeal.

However, there is one feature that the greenback possesses and none of its alternatives come close to matching is its liquidity —- it is the primary reserve for the world. And when market fear turns into panic and the regular functioning of the markets gets disrupted, market participants and investors look for liquid assets. That means the US dollar, US Treasuries and US money market funds are seen as a last resort.

We have now seen the break in bullish momentum that began back in the first quarter of 2009 and was fuelled by stimulus. Markets are unwinding risk.

Risky assets sell-off and the dollar rally may remain the dominant trend for now. There are always corrections in larger moves. And, when it comes to a panic selloff, there is a far greater precedence for policy intervention. In these instances, policy officials look to force a calm. The Fed has tapped out of further stimulus. Efforts to stem the European crisis have been ignored because of in-fighting and the sheer cost involved with the expected recovery.

Coordinated efforts from major global central banks and key global economies are possible in the foreseeable future. These moves can generate short-term relief for the market but they are unlikely turn the tide.

In the local market, the momentum driving the rupee lower seems somewhat similar to the pressure seen after the global financial crisis in October 2008. The global market conditions remain unfavourable for most Asian currencies. And it is the global price action characterised by extreme risk aversion that will continue to drive the rupee. Under such conditions, the rupee-dollar pair can once again test the level of 52, last seen in March 2009. The sharp depreciation seen in the rupee would most certainly see some support coming in from the RBI in terms of dollar selling, even though the intervention may be limited by tight rupee liquidity conditions and hence the central bank may resort to sell-buy swaps in the spot/forward market. Over the weekend, the RBI increased the external commercial borrowing limit under the automatic route to $750 million per financial year from $500 million, to help attract more capital flows. Over this week, the rupee dollar pair can trade in the range of 49.25-51.

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