The Indian rupee bounced off a near three-week low touched in early trade on Tuesday after a disappointing central bank policy statement and as a key ally withdrew support from the ruling coalition government.
The withdrawal of support is seen jeopardising Prime Minister Manmohan Singh's economic reforms but poses no immediate threat to the minority government, which can survive with the support of other parties.
The central bank cut its key lending rate as expected, spurring a brief rally in markets, but warned that scope for further easing was limited, prompting markets to soon start reversing the gains.
"Political stability is the new concern now. The market was caught short following the rate cut decision, and hence the USD/INR spiked up," said Vikas Babu Chittiprolu, a senior foreign exchange dealer with state-run Andhra Bank.
"Going ahead we may see a range of 53.90 to 54.60 on the USD/INR this week. Unless some new event crops up in the euro zone, I expect the USD to be capped at 54.60 on the top," he added.
The partially convertible rupee closed at 54.37/38 per dollar, weaker compared with its close of 54.1650/1750 on Monday. The rupee strengthened to as much as 53.9050 in early trade, its highest since Feb. 28.
Shares fell the most this month on Tuesday after the withdrawal of a key ally.
"The rupee looks weak in the short-term now. We could see 55 levels depending on the developing political scenario and the pace at which it evolves," said Ashtosh Raina, head of foreign exchange trading at HDFC Bank.
In the onshore forwards, the 1-year premium shot up to 357 points compared with 350.25 points at the previous close, while the six month rose to 200 points from 194 points.
In the offshore non-deliverable forwards, the one-month contract was at 54.81 while the three-month was at 55.42.
In the currency futures market, the most-traded near-month dollar/rupee contract on the National Stock Exchange, the MCX-SX and the United Stock Exchange, all closed at around 54.47 with a total traded volume of around $9.4 billion.