Dollar’s strength will decide how rupee

Post-earthquake nuclear crisis in Japan gripped global financial markets last week and led to volatile swings and fading investor appetite for risk. There was some improvement in risk appetite on Friday in the wake of the first co-ordinated international intervention in the currency markets in 10 years.

Support for Japan by the Group of Seven (G7) leading industrial nations to weaken the Japanese yen after it hit record highs mid-week helped to revive global stock markets and stemmed gains for safe haven assets such as US Treasuries and the Swiss Franc. China’s decision to raise reserve ratio requirements for its banks threatened to check the improved mood on Friday, but the news of a ceasefire in Libya that reduced tensions in the troubled region restored positive momentum.

In the currency market, the yen fell sharply from a record high against the US dollar last week after the G7 richest nations committed to intervene together in the market to stem yen appreciation in order to prevent the export-oriented Japanese economy slipping back into recession. This represented the first such joint intervention since major central banks joined forces to support the Euro in 2000.

The yen was pushed to a record high of Y76.25 against the US dollar on Thursday amid growing concerns over the nuclear crisis triggered by the earthquake in Japan. The yen climbed as market participants reasoned that Japanese institutions would repatriate funds to deal with the aftermath of the disaster and rebuild Japanese economy. Safe haven demand for the yen was also triggered by a broad based rise in risk aversion across the global financial markets.

The yen sold off aggressively after the G7 intervention on Friday, falling 2.3% against the US dollar, losing 3.4% against the Euro and dropping 2.8% against the pound on the session. The Bank of Japan (BOJ) sold an estimated about yen 2000 billion ($25 billion) against the greenback on Friday. The European Central Bank and the central banks of France, the UK, Germany, Italy, Canada and the US Federal Reserve all followed the BoJ’s lead and sold the yen, albeit in much smaller amounts.

The yen, which at its strongest on Thursday was up nearly 7% against the greenback since the start of week on Monday, ended the week up just 1.6%.

Meanwhile, rising risk aversion boosted safe haven demand for the Swiss franc, sending it to a record high against the US dollar on Thursday. The franc eased on Friday, still up 3.1% against the greenback over the week.

The US dollar also fell 1.9% against the Euro over the week and eased 1% against the Pound. The Euro benefited during the week after policymakers progressed to strengthen Europe’s bail-out fund while market participants shrugged off a Moody’s downgrade of Portugal on Wednesday and focused on a successful sale of Spanish government debt on Thursday

Fading risk appetite took its toll on commodity-linked currencies. Over the week, the Australian dollar fell 1.8% against the US dollar, the Canadian dollar lost 1.2% and the New Zealand dollar dropped 1.6%.

In the local interbank market, rupee appreciated a tad against the US dollar following the weakness in the greenback globally. Local stock markets remained volatile and lost value of the week, putting rupee under pressure. In the mid-quarter review of monetary policy statement, the RBI sounded more sanguine on the current account deficit situation compared to its January review in light of improved exports in recent months. The rupee-dollar pair traded in a narrow range 45.035 - 45.3625 and the Indian unit appreciated by 0.3%.

In recent weeks, the US dollar has been weakening despite rising investor risk aversion. The greenback is one of the safe haven currencies with deep and liquid financial markets and therefore the current bout its weakness is some what puzzling. Against its two major peers, Japanese yen and the Euro the decline has been particularly sharp. However, that may not persist for long.

The devastating earthquake Japan suffered has contributed to uncertainty on a global scale but it has also encouraged a carry trade unwinding and a repatriation effort by Japanese institutions. These drivers will work for some time and the multilateral intervention effort to stem yen appreciation from the G7 will help.

The strength of the Euro advance is also questionable. The ECB has sounded the alarm that a rate hike could be on the cards next month — which has helped the Euro. It is very unlikely this will lead to a series of hikes and furthermore Europe is facing a credible threat to its financial stability given its underlying sovereign credit issues.

For guidance on other critical influences, market participants would watch the equity market movements, the EU summit on Thursday and Friday, the UK CPI figures on Tuesday and the situation with the Japanese Fukushima nuclear plant. In the US there are notable economic indicators like durable goods and the Chicago Fed National Activity Index due for release this week. However, any Fed commentary could prove far more influential for rate speculation.

In the local inter-bank, rupee seems to have settled into range against the US dollar. While domestic fundamentals, particularly rising inflation, weak stock market and heavy reliance on imported crude oil, are negative for the rupee, the Indian unit has been able to withstand these in recent weeks on the back of sharp slide in the dollar in the overseas market.

Otherwise market participants remain concerned about the slowdown in durable capital inflows like FDI, worsening of the investment climate in the country and high global crude oil prices. Any meaningful movement in the rupee-dollar pair would therefore depend upon on the general strength or weakness of the US dollar in the overseas markets.

Local fundamentals remain largely unfavourable to the rupee. It is crucial therefore to watch the movements in the US dollar in the overseas market. A rebound in the greenback could bring about a sharp slide in the rupee. Until then the rupee-dollar pair would continue to trade in the range established over recent weeks.

The writer is senior economist, Royal Bank of Scotland NV. Views expressed herein are personal. E-mail: gaurav.kapur@rbs.com