Swaps and the end of the rate hike cycle

Swaps and the end of the rate hike cycle

The recent spate of depressing economic data has kicked off a debate whether the Reserve Bank of India (RBI) should pause in hiking interest rates. Yes, the consensus opinion among pundits is that the central bank would raise rates by 25 basis points in the mid-quarter review on Thursday. One basis point is one-hundredth of a percentage point.

However, there is also an opinion among a section of the market that the end of the rate hike cycle is nigh. A look at the five-year overnight index swap (OIS) rates shows that yields have fallen by 80 basis points in the past month, with the decline accelerating since the beginning of June.

The basis for that reasoning is not hard to see. Commodity prices have been correcting since the beginning of May. The US is not recovering as expected, China is showing signs of a slowdown and the euro zone has to deal with its own debt restructuring problems.

In India, April wholesale price inflation has softened a bit. At the same time, factory output and purchasing managers’ indices point to a slowdown in growth. The latest economic growth figures also show that investment demand growth almost halted in the three months to March.

In other words, there might be some justification for RBI to moderate its hawkish stance.

But recent hikes in minimum support prices for foodgrain and a long-awaited hike in diesel and cooking gas prices by the government mean that inflation can’t be just wished away. Those factors will influence the monetary policy, at least in the near term.

If one looks at the one-year OIS rates, yields, while falling, are nowhere declining as fast as longer-term rates. In fact, the OIS yield curve has inverted, indicating that short-term rates are higher than the longer-term rates. The one-year swap is now at around 7.9%, indicating the market is expecting a rise of another 50 basis points or so in the repo rate in a year, while it could also be high due to the tight liquidity. Remember, banks borrowed Rs75,000 crore through RBI’s repo window the previous week.

With interest rate hikes at the end of the curve, bond prices may not rise further, while yields are likely to stay in a tight range. Given the arbitrage with developed markets, that perhaps explains why foreign institutional investors have piled on to local bonds, buying $3.23 billion (Rs14,500 crore today) of debt compared with $85 million of equity so far this year.

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