Greater investor risk appetite may drive rupee higher

In the financial markets last week, broad market sentiment showed early signs of decoupling from the specific concerns over euro-zone government debt.

Markets seemed to reflect some optimism given that the prospects for a widespread liquidity crisis appeared to be receding and real economic fallout from the European crisis might be limited for most countries. This helped support a rally in risk appetite that drove a rebound in global equity markets over the week.

In the currency markets, the euro advanced last week, buoyed by easing concerns over the euro-zone financial system and a rebound in investor risk appetite. Worries over Spain’s finances were heightened earlier in the week on reports that the country was to ask the International Monetary Fund, the EU and the US Treasury for financial assistance. The European Commission denied these reports though.

But concerns over Spain’s ability to service its debt eased after the country raised €3.48 billion in the bond market on Thursday. Other European economies have also managed to raise debt relatively easily. A decision by euro-zone officials to publish the results of the stress tests on European banks by end July also helped soothe worries over the health of the region’s financial system.

The bounce in the euro was partly due to covering of short positions by some market participants. In fact, the most recent CFTC Commitment of Traders report showed that non-commercial traders (speculators) scaled back their long US dollar positions against the euro by a record amount in the week ending June 15 — emphasising the sharp sentiment shift among market participants.

The euro rose 2.3% to a three-week high against the greenback over the week.

Meanwhile, stability on the global stock markets kept safe-haven demand for the greenback in check. The US dollar fell 2% to a one-month low against the pound over the week and lost 1.1% against the Japanese yen.

The Swiss franc climbed to a record high against the euro after the Swiss National Bank on Thursday dropped its pledge to fight “excessive appreciation” of its currency and moved towards an exit from its ultra-loose monetary policy stance.

The central bank surprised investors with a hawkish message after its policy meeting, saying the deflationary risks to the Swiss economy had “largely disappeared”. The Swiss franc rose 1.3% against the euro on the week and climbed 3.5% against the US dollar.

Commodity-linked currencies also performed strongly, with the Australian dollar climbing 2.6% against its US counterpart over the week and the New Zealand dollar rising 2.7%.

Rising risk appetite also boosted emerging market currencies, sending the South Korean won up 3.5% against the greenback on the week, the Brazilian real 1.5% higher and the South African rand up 1.5%.

The Indian rupee also appreciated by 1.4% against the US dollar last week. Improved global risk appetite and weakness in the greenback in the overseas markets helped the Indian unit gain ground.

Local stock market rallied by 3% over the week and the FIIs bought $635 million worth of Indian stocks and bonds, as appetite for risk made a comeback.

That, in turn, helped the rupee appreciate against the US dollar on hopes of improving capital inflows into the economy, especially portfolio inflows. The rupee-dollar pair traded in the range of 46.09 - 46.75 during the week.

In the week ahead, the movements of the US Dollar will continue depend on the trajectory of the US equity markets and broader risk appetite. Given its influence over the financial market sentiment, it will be important to watch reactions to Wednesday’s US Federal Reserve Open Market Committee (FOMC) interest rate decision.

Interest rate swap markets show that the market participants have priced in “zero” probability of an interest rate hike in this meeting, but the event may nonetheless spark volatility on the accompanying statement.

Markets at large expect that the US Fed will leave rates and monetary policy stance unchanged, but any surprises could force substantial moves across financial markets.

The key question may be whether the relatively hawkish minority within the FOMC becomes more vocal in their calls for a withdrawal of unprecedented monetary policy stimulus. Uneasy conditions in financial markets and relatively mixed evidence of an economic turnaround suggest that the FOMC will leave policy statement largely unchanged. Yet such effectively neutral market expectations may make for especially large volatility on any subsequent surprises.

Given relative complacency in financial markets, the safe-haven US dollar could continue to slip lower against the euro and other key counterparts. A hawkish shift by the US central bank could, however, break this relative calm in the markets.

The Indian rupee could remain on a strong footing this week too given that investor risk appetite is unlikely to be squeezed by key scheduled events and the general financial market conditions. The upside may, however, be limited considering that caution is likely to prevail among market participants as the euro-zone sovereign debt issue unfolds now with Spain under scrutiny.

Moreover expectations that the RBI could raise rates before its July 27 monetary policy meeting, as inflationary pressures are becoming more generalised, can also act as a drag on the stock market. Overall, the rupee-dollar pair is likely to trade in the range of 45.80 - 46.50 this week with an appreciation bias. Rupee remains somewhat overvalued in trade weighted exchange rate terms. However, rising inflation, both in absolute terms and in relation to its key trading partners, has increased the risk of greater overvaluation.
 
The writer is senior economist, Royal Bank of Scotland N.V.
Views expressed herein are personal.
E-mail: gaurav.kapur@rbs.com