Mumbai: The bond market expects India’s central bank to reverse its stance soon and cut interest rates at a much sharper pace than it did in 2008 in the wake of the global credit crisis.
The expectation contrasts sharply with reality: the Reserve Bank of India (RBI) has been on a rate hiking spree and, last week, raised its policy rate for the 12th time since March 2010.
The market’s perception of interest rate movement is gauged through the overnight index swap, or OIS, curve.
OIS is an interest rate swap instrument in which the overnight rate is exchanged for a fixed interest rate and is used for hedging against the yield movement in government bonds. Simply put, OIS indicates the interest rate investors are willing to pay for a specific period.
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The one-year OIS rate is now 7.97%. Typically, longer maturities mean higher interest rates, creating a gap or spread between different maturities.
In normal circumstances, the spread is positive as the market expects to pay higher interest rates for longer maturity loans. When the spread turns negative, it indicates that the market expects interest rates to be cut.
Currently, the one-year OIS rate is higher than the two-year and even the five-year OIS rates. The negative spread is even deeper than what was seen in September 2008. This means the market is expecting rate cuts to be sharper this time than in 2008.
Graphic by Ahmed Raza Khan/Mint
To fight the impact of global slowdown and prop up demand in a slowing economy, RBI brought down its policy rate from 9% to 3.25% between September 2008 and April 2009.
The OIS curve has been quite accurate in predicting interest rate movement in the past.
“It is a smart curve; pretty much catches the top and bottom of interest rate movements,” said A. Prasanna, chief economist of ICICI Securities Primary Dealership Ltd that buys and sells government bonds.
“Having said that, a lot of the movement in the curve today is driven by the memories of 2008. If 2011 is different from 2008, then the curve is not right as it is pricing in aggressive outcomes. At this point, I see it as an anomaly, but if the euro zone problems spin out of control then the curve will prove to be spot on as it had in the past,” he said.
Prasanna pointed out that public sector banks who trade actively on the bond market largely stay away from trading in OIS. Liquidity has also come down as banks, mostly foreign ones, have strict limits on the positions they take.
The forward rate agreements (FRAs) also indicate that the market is expecting interest rates to come down sharply. FRA is an over-the-counter forward contract that roughly indicates the overnight call money rates at a specific period in future.
Going by FRA rates, in the next three months, the call money rate will be around 8.4%; between three and six months, it will be at 7.97%; between six and nine months at 7.54%, and between nine and 12 months at 7.1%.
The overnight call money rate on Tuesday was 8.3%.
“Broadly speaking, the higher end of the OIS curve indicates that RBI will cut rates and bring back liquidity in the system. The forward-looking view on the interest rate is benign,” said Nitin Jain, managing director and co-head of fixed income at Nomura Fixed Income Securities Pvt. Ltd.
Most bond market dealers said RBI doesn’t give much weightage to these numbers while formulating its monetary policy.
“RBI, in private, says these are theoretical curves and do not indicate the domestic reality. But there is a reason why these numbers are there and in the past they proved right in predicting (interest rate) moves,” said the head of treasury at a foreign bank, who did not want to be identified because his bank’s policy does not allow him to speak to media.
RBI’s decision is more driven by the yield movement on the bond market rather than OIS curves. Bond yields, unlike OIS, are not falling dramatically.
“The fact that 10-year bond yields are at around 8.33% and they have not moved much after the last week’s rate hike shows a benign interest rate environment. This is despite the continuous supply of bonds and the fact that banks are sitting at 4-5% excess SLR (statutory liquidity ratio). If the view was that interest rates would not come down, bond yields would have shot up,” said Nomura’s Jain.
SLR is the portion of a bank’s deposit required to be invested in government bonds. Currently, SLR is 24%, but in the absence of a pickup in credit, banks are investing more in government bonds.
Many economists and analysts have started predicting that RBI will reverse its policy stance and start cutting rates in the first quarter of fiscal 2013.
Several companies have stopped taking loans from banks because of the rising cost of money. Industry lobbies have criticized RBI for hiking rates and have been demanding a reversal of stance. In its 16 September mid-quarter policy review, RBI said it would consider changing its stance only when inflation comes under control. Inflation in India is close to double digits, much above RBI’s comfort level.