The Hindu Business Line : Mid-term policy review

There are many who believe that the central bank will leave rates unchanged and there are a few who think that it will move rates by fifty basis points. Most of the market participants, however, feel that a 25 basis point hike in the repo rate is the most likely outcome.

To my mind, the probability of a 25-basis point hike in the repo rate and no hike at all are almost equal. It looks unlikely that the central bank will move by fifty in one go. No one can deny that the economy is on a clear upswing. All the economic data that have come out in the last six months to a year point to a sharp recovery.

Given the current level of prices of commodities, including crude oil, and our recent experience with the pass through of these in manufactured products, it is highly likely that inflation will soon start rising again.

In a nutshell, the probability of a hike in interest rates by the central bank in the next three months is close to 1. I think it's a question of when rather than whether.

The RBI can hike rates by 25 basis points now or can choose to give the investment-led recovery some more time before it moves on rates. It all depends on how urgent it perceives its need for action to be. All I am trying to say is that RBI not hiking rates in the policy does not significantly alter the overall outlook on interest rates. If there is no hike in the policy, it will happen for sure in some time.

Given that the bond market will go into the policy slightly long, if there is no hike, the 10-year sovereign yield is likely to touch 6.50 per cent whereas a 25 basis point hike will surely see it go to 6.75-6.80 per cent.

A 50 basis point hike in the policy will push yields back to the record highs of close to 7 per cent for 10-years. The recent dip in the headline inflation number has provided comfort to the market and most participants will go loaded up slightly more than what they had initially planned to take into the policy.

Similarly, the 5-year OIS (Overnight Index Swaps) has a 6.05-6.55 range depending on the policy outcome. No hike will take it to 6.05 per cent, a 25 basis point hike will most likely take it to 6.35 per cent whereas a 50 basis point hike will definitely push it above 6.50 per cent.

Wherever the market settles after the policy, I think one should pay the OIS and sell bonds at those levels. The overall outlook on rates is still negative and will continue to be so for some more time.

Both the OIS and bond markets have rallied into the policy as the market participants have increased their longs. The forwards however, have not come off at all in this move in spite of the rupee showing clear signs of strengthening. The short-term forward rates have actually gone up in the last rupee appreciation move.

Clearly, corporates are still not convinced of the rupee strength and have used all dips as buying opportunities whereas the money books have not received the premia because of the fear of a hike in the repo rate.

Hence, I think the risk reward in going long into the policy is best on the forward curve followed by OIS and then bonds. Capital flows, global dollar weakness and the China revaluation story will hopefully keep the rupee strong.

Oil continues to be a significant cause of worry for the rupee. Our oil import bill for the first half of 2004-05 is almost $5 billion more than last year. The trade deficit has also expanded by a similar amount in this period, which means that the export growth is just about taking care of the growth in non-oil imports.

Given the way crude is behaving, most likely we shall see a $14 billion jump in our oil bill for the year. We had shown a $10 billion current account surplus last year, which will be comfortably consumed by the oil bill this year. Thanks to it, the country shall most likely post a small current account deficit this year after registering three consecutive years of expanding surplus.

So the strength of the rupee will largely depend on the capital flows this year.

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

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