By Jaspreet Kalra

MUMBAI (Reuters) - The Indian rupee faced its most challenging week since February, largely influenced by significant shifts in U.S. trade policy that have triggered notable volatility in global markets. This financial upheaval not only pressured risk assets but also had a pronounced impact on the U.S. dollar itself, ultimately helping to moderate the rupee's losses.

Closing the week down by 0.9%, the rupee settled at 86.04 per U.S. dollar on Friday, marking a decline of 0.7% for the day. Despite this drop, the rupee managed to find some support against the backdrop of a weakening dollar, as traders began to adjust their positions.

On Friday, the sentiment surrounding the dollar turned increasingly negative, which inadvertently boosted several Asian currencies, including a slight increase of 0.1% for the offshore Chinese yuan. This occurred despite heightened tensions between the U.S. and China regarding trade, with Beijing recently announcing a massive tariff increase on U.S. goods, raising them to a staggering 125%. This decision comes as a direct counter to U.S. President Donald Trump's imposition of a 145% tariff on Chinese imports.

As the dollar index plummeted by 0.7%, reaching a three-year low, investors expressed growing concerns about a potential U.S. recession, which has shaken their confidence in American assets. Although the U.S. government has paused implementing reciprocal tariffs for most countries, this exclusion does not apply to China, leading to further instability in the dollar's performance. The euro and other safe-haven currencies, notably the Japanese yen and the Swiss franc, have also benefitted from the dollar's decline.

In a recent report, MUFG Bank emphasized the challenges the dollar faces, stating, In this environment it is hard to see any near-term revival in U.S. dollar confidence. This sentiment is echoed in the market as traders reevaluate their positions, leading to a notable shift in dollar-rupee forward premiums following interbank dollar sales. Additionally, there has been a slight reduction in expectations that the Federal Reserve may lower interest rates as early as May, with the one-year implied yield decreasing by 8 basis points to 2.25%.

Market analysts note that the future trajectory of the rupee will heavily depend on the sustainability of the dollar's recent downturn and how the Chinese yuan responds to evolving U.S. trade policies. A weaker yuan could lead to upward pressure on the USD/INR exchange rate. However, if the dollar continues to weaken, it may ease some of the pressure on the rupee. A Singapore-based trader at a bank remarked, If the yuan weakens, markets will try to push up USD/INR but a weaker dollar could lighten the pressure.

(Reporting by Jaspreet Kalra; Editing by Varun H K)