The Hindu Business Line : Rising interest rates to take a breather

The benchmark 10-year government bond yield, which was around 5.10 per cent at the end of April, is now close to 5.85 per cent. Various factors have played their part in this pull back. Rising domestic inflation, hardening of rates overseas, end of a one-way rupee strengthening story and a change of Government at the Centre are the ones that come to my mind the first.

Actually, the swap rates have risen more than bond yields. The five-year currency swap rates have gone up by almost 200 basis points in the same period. The five-year OIS rates have not risen as much but are a good 120 basis points higher than where they were end of April. The currency swap rates have risen faster because not only have the interest rates gone up, even the view on the rupee has undergone a dramatic change.

The rupee had been steadily appreciating over the last year on the back of good FII inflows. The one-way appreciation had caused a bit of complacency among the corporates who started to believe that the rupee could only go one-way, i.e. appreciate. The whole market slowly got leveraged and completely on one side, every one was sitting short dollars. This one-way leverage was getting reflected in the sharp jumps in the banking capital component of the quarterly BoP data, which eventually caused an acute shortage of dollars.

Forward premia went negative, as banks were desperate to cover their negative nostro balances at any cost. I remember the one-year trading at - 35 paise.

The market's complacency was broken when drying inflows coupled with continued RBI intervention caused the rupee to stop appreciating and actually lose a bit of ground against the greenback. That's when one suddenly realised that there were no sellers left in the market and everyone was waiting for an opportunity to cover back their shorts. The rupee has depreciated by more than five per cent since then. As the leverages slowly reduced and RBI sold dollars to support the rupee, the dollar shortage sorted itself out. The short covering by corporates and the balance sheet paying by banks pushed the forwards higher, thereby causing an equally sharp rise in currency swap rates.

There is no doubt that rates have gone up sharply and that the overall view on rates continues to be negative. But we should see rates taking a bit of a breather for now as they have gone up too much too soon and there are some possible positives on the horizon.

A possible softening of the Finance Minister's stance on the transaction tax and an EPF rate reduction in their July 20 meeting could provide some temporary relief to the interest rate markets. But more importantly, the US economy seems to have clearly hit a soft patch and the threat of a weak monsoon domestically is slowly gaining ground.

A weak monsoon is inflation-negative but it will definitely dampen rural demand, thereby causing a bit of an economic slowdown. I have called these two factors `possible positives' because the soft patch in the US economy could indeed be temporary and the threat of a weak monsoon, unreal.

One will have to wait and see how these two factors span themselves out before taking a strong view either way.

Domestic inflation though, continues to be a worry. The year-on-year WPI inflation could go up further over the coming weeks and even breach the 6.50 per cent level. The table gives year-on-year core inflation for a few important economies and respective yields on their 10-year treasuries.

The numbers do not say much, but definitely give you some idea about where our real interest rates are and may be where they should be.

I have no clue as to what our real interest rate should be, but it is definitely out of line with that in the other countries in the table. Just to remind you, our year-on-year inflation has gone up by almost 500 basis points from the lows seen, whereas our interest rates have gone up by not more than 100.

Again it does not say much, but is still worth keeping in mind.

(The author is a senior trader, Interest rates at HSBC, Mumbai. The views mentioned herein are his own and not necessarily those of his employer.)

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