Foreign exchange markets are bracing for heightened volatility on Monday morning as the reaction to Standard and Poor's lowering of US long-term sovereign credit rating to AA+ from AAA sets in.
It is obvious that global investors would consider diversifying their assets out of US treasuries. This move can apply pressure on the dollar. There is also fear that some funds which are not allowed to hold any asset without AAA rating might be forced to sell treasuries in the near term.
However, it is hard to envisage a total collapse of the greenback as no investor can claim that he was unaware of the state of the US economy or the risks associated with investing in dollar-denominated assets.
Sorry decade
This sorry state of affairs is reflected in the dollar consistently moving lower against major currencies for more than a decade.
The best way to track the dollar movement is through the dollar index that tracks its movement against a basket of five currencies -euro, pound, Swedish krona, Swiss franc and the Japanese yen. This index moved lower between 2001 and 2008 from the peak of 121, when the bull market was raging in equities across the globe.
Though the index reversed in 2008 with US investors bringing money back home in the aftermath of the sub-prime crisis and the Lehman debacle, it could not rally beyond 90 and has been fluctuating in a band between 72 and 90 since then. It is currently at 74.6.
Impact of downgrade
Though the dollar may depreciate against the yen, European currencies are also likely to be under duress due to the ongoing debt crisis in European nations. This can help stem the erosion in the dollar index to some extent. The low of 70.7 recorded on March 2008 is the immediate support that markets will be watching. This is a multi-year low for the index and intervention by US government is also likely if this level is breached.
However, a strong move below this level will take the index lower to 57.8 over the medium-term.
Rupee equation
Rupee closed at 44.7 against the dollar on Friday after reversing from the key support at 44 on July 27. The 44 level is a very important technical hurdle for the Indian currency; and the currency has bounced off this level four times since April 2010. The RBI is also seen to intervene in forex markets every time the currency nears this level.
If there is sharp depreciation in dollar in the aftermath of the downgrade, rupee could first appreciate to this 44 mark. It is possible that the appreciation halts here as FII outflows triggered by continued correction in equity prices can exert pressure in the opposite direction.
If the rupee appreciates above 44 against the dollar, subsequent targets are 42.6 or 41.8.
Gold can dazzle
Increase in risk aversion has always made investors flock to gold, and the yellow metal is already at a heady height, having appreciated 18 per cent this calendar year. As more funds are allocated to gold over the upcoming months, gold can continue spiralling higher on course to our long-term targets of $1,867 and $2,587.