When will RBI hike rates? Follow the yield curve to know
India’s sovereign yield curve is at its steepest since 2011 with the difference between short-term Treasury bill yields and long-term government bonds as wide as 100 basis points now (100 basis points equal one percentage point).
The steepening yield curve denotes how markets are always way ahead of central banks in anticipating future inflation. Central banks are seldom ahead of the curve in pricing money since markets always price in data faster and second-guess central bankers to move to the next level. The Indian bond market and the Reserve Bank of India (RBI) are no exceptions.
The benchmark 10-year government bond yield has climbed 33 basis points since the monetary policy in October. What drove this rise is the increase in retail inflation to 3.58% in October due to a broad-based rise in prices of most items. The potential upside bias to inflation from the upswing in global commodity prices was captured by bond yields. That central banks in advanced economies have begun unwinding their balance sheets is also reason enough for interest rates to go up.
But does the bond yield curve hold clues on when RBI will hike interest rates?
In past episodes when the spread between short-term and long-term yields has widened, policy tightening has followed approximately after 9-12 months. For instance, in 2009 the sovereign yield curve began steepening in January and was the widest in October. RBI started raising rates in March 2010. Another episode is the steepening of the curve that began in early 2006 and the central bank began raising its cash reserve ratio and its policy rate by the end of that year.
Put this in the current period and the steepening of the yield curve portends a rate hike around June 2018 and beyond.
But this analysis is far from being cut and dried, because the movement of bond yields is not strictly limited to expected inflation but they also react to prevailing liquidity and supply under the government’s borrowing plan.
Moreover, the liquidity management framework of RBI has undergone a huge change over the last two years, triggered by the exogenous factor of demonetization in fiscal year 2017. From an accommodative stance to bringing the liquidity to neutral, RBI’s interventions have also played with the yield curve this time.
Nevertheless, analysts feel that the central bank would find it hard-pressed to increase interest rates for at least two quarters and some like UBS Securities India Pvt. Ltd believe there would be no hikes in 2018. It would be interesting to see whether the markets get it right.