Mumbai: Investors should enter interest rate swap contracts in India to profit as the cost of one-year borrowing climbs faster than that of two-year debt in the coming months, according to Morgan Stanley.
Traders should agree to make one-year fixed rate payments and receive a floating rate to gain as the Reserve Bank of India (RBI) raises borrowing costs from a seven-year high to curb inflation, Linan Liu, an analyst at the second biggest US securities firm by market value, wrote in a research note.
They can also do an opposite transaction in the two-year segment to benefit as the spread between one- and two-year rates widens, he said.
“India’s interest rate curve is already inverted and that trend should gain momentum over the next three to six months,” Liu wrote, referring to the faster increase in short-term rates. “One-year swap rates should increase their spread over two-year ones because we may see further monetary tightening until inflation is contained.”
The cost of one-year swaps rose faster than two-year rates in the past 11 trading days, widening the spread between them to 16 basis points. The one- and two-year swap rates were at 9.7725% and 9.61%, respectively, at close in Mumbai, according to data compiled by Bloomberg. A basis point is 0.01 of a percentage point.
Inflation check: RBI’s Y.V. Reddy
Morgan Stanley forecasts the difference between the two rates will increase by as much as 30 basis points in the coming three months as RBI adds to monetary tightening measures taken this week. That would take the spread to 45 basis points, the most since September 2001.
RBI governor Y.V. Reddy increased the overnight lending rate to a seven-year high of 9% from 8.5% on 29 July and also raised the proportion of deposits banks must hold in reserves to 9% from 8.75%.
The central bank also lifted its inflation forecast for this year to 7%, having previously predicted the rate wouldn’t exceed 5.5%.
“The aggressive policy response from RBI seems to suggest that the central bank prioritizes inflation over growth to anchor price expectations,” said Liu, who confirmed the contents of the report.
One-year swap prices will rise faster than two-year rates also as money market rates climb amid declining cash in the banking system, according to Morgan Stanley. “Liquidity in the financial system is biased to tighten, aiding the inversion of the swap curve.”
Banks’ dependence on overnight loans from the central bank more than tripled this month, suggesting they are short of cash.
The average cost of overnight borrowings between banks rose to 8.7% this month from 7.6% in June, according to data compiled by Bloomberg.
Money at banks will decline as lenders hold more cash in reserve to meet new regulations and the government sets aside more money with RBI, diverting funds away from the financial system, according to Liu. He predicts, using historical averages, the government’s deposits with RBI will rise as much as five times to Rs1 trillion by 31 March.
“The risks to our call are a surprise easing in liquidity, a sharp correction in inflation expectation or a change in the hawkish stance of the RBI,” Liu wrote. “Currently, we assign a low probability to such scenarios.”