Dollar index may move to 89 level euro/dollar to 1.20

The dollar index has been volatile since the 2008 financial crisis. During the last three years, the dollar index has been very volatile, forming a strong base around 73 and resistance around 89; with two-way volatility of around 20 per cent. The volatility may be attributed to the shift of investment flows into and outside of the US, based on the global risk perception. When there is pressure on the global economy, the dollar gains from its safe haven status to attract investment flows, with money chasing less-risky assets, unmindful of lower return. On the other hand, when things are normal, funds flow out of the US to high-risk (high return) assets of other major and emerging economies. The euro zone crisis (and the resultant risk aversion) has pushed the index from 72.70 to 80.73, up 11 per cent in six months. During this period euro/dollar fell from a high of 1.4909 to a low of 1.2944, down 13 per cent. There is more or less a parallel shift between the euro/dollar and the dollar index, since the emergence of the euro zone (and euro currency) as an alternative to the US.

What is the way forward? The crisis in the euro zone continues to stay valid. The financial crisis has transformed into a sovereign crisis, pushing sovereign yields sharply and leading to rating downgrades of most European nations. The belief is the worst is yet to come. On the other hand, US economy is showing signs of improvement and economic data during the last couple of weeks are encouraging. The relative out-performance of the US over the euro zone, and the risk of the global economy getting into a recessionary trap will keep the dollar strong for an extended period of time. There may be another round of quantitative easing, both from the US and the euro zone, to arrest growth pressures and support weak equity market. Till then, risk aversion will continue to divert investment flow into the US, thus driving the dollar index close to 89. This expectation sets euro/dollar target at 1.20-1.17, with the risk of extended rupee weakness into 56-58. However, RBI's measure will significantly cut the demand from export cancellations; thus providing good support for the rupee at 54. However, external fundamentals being weak, we need to see its impact on rupee and its ability to stay in consolidation mode at 52-54.

Given these expectations in the short term (three-six months), it is important for exporters to cover euro exposures against the dollar, while keeping the dollar/rupee open. On the other hand, importers can keep euro/dollar uncovered while covering the dollar/rupee exchange rate. This scenario is valid till the global economy shifts from the current ‘risk-off’ to ‘risk-on’ mode, to enable investors to take higher risk in search of higher return. It is critical for the euro zone to get back investor confidence. Eliminating the risk of disintegration of the zone would drive the dollar index back to 73. This will redress the economic woes of the emerging economies.

The author is executive vice-president, IndusInd Bank