The Hindu Business Line : Inflation holds the key

The wordings of the policy and the ongoing soft patch in the US economy have somehow managed to convince the market that the next rate hike is far away, if at all.

THE two big market drivers in the last fortnight have been the RBI's monetary policy and strong rumours of an imminent Chinese yuan revaluation.

In an unexpected move, the central bank hiked the reverse repo rate by 25 basis points. The move was unanticipated because of two reasons.

One, after having spiked in the first half of the last fiscal, inflation had come down quite significantly in the second half.

Two, on occasions more than one, the Finance Minister had suggested that rates would not be hiked over the next six months.

The RBI, however, chose to be proactive and went ahead with the hike. Removal of monetary accommodation by central banks worldwide and the need to establish RBI's commitment to managing inflationary expectations seem to be the key factors behind this decision.

Although a large section of the market did not expect Dr Y.V. Reddy to hike rates, the conviction was not strong enough for them to bet on it. As a result, the market went into the policy with small positions and hence we did not see a big sell-off later.

Moreover, the levels across all rate markets were kind of pricing in a 25 basis points hike some time in the future.

Pre-policy, one-year OIS at 5.45 per cent with overnight rates at 4.75 per cent clearly meant that the market was pricing in a hike going ahead. It's just that the hike came in sooner than expected.

To start with, all rate markets reacted almost uniformly to the policy action by moving up 10 basis points.

Later, bonds took the brunt and all other markets actually recouped more than half their losses. OIS rates are hardly five basis points higher than where they were before the policy.

Currency swaps are actually at almost the same level, if not lower.

Govys have clearly suffered; at 6.90 per cent, the 5-year govy is almost 25 basis points higher than its pre-policy level. Out of this 25 basis points move, 10 were on account of the rate hike and the rest on the back of the Rs 6,000 crore auction that we saw last week.

It only goes to show the continued apathy of public sector banks towards bonds. An auction has managed to move rates by more than the actual hike.

The wordings of the policy and the ongoing soft patch in the US economy have somehow managed to convince the market that the next rate hike is far away, if at all.

Six months and one-year T-Bills at 5.33 per cent and 5.60 per cent respectively with the reverse repo rate at five per cent clearly tell you that.

Although at this point even I believe that we may not see a rate hike soon, but expectations can change if inflation starts to move up again, which it did last month. There is a risk of rates moving higher if expectations in the market get revised going ahead.

However, if point-to-point inflation stays in the 5-5.50 per cent band, then I don't see the 5-year govys go much above 7 per cent.

The 5 cross 10-year flatness in the govy curve is increasingly getting difficult to explain, more so in a bond apathy environment.

I cannot understand the motivation of investors buying 10-year bonds at hardly 35 basis points over the 5 years in an uncertain interest rate environment.

I have never been a great proponent of 5 cross 10-year steepener trades; unless it has gone below 20 basis points or so. But in the current environment where the rate outlook is far from certain, increasing your interest rate risk by almost two-thirds for less than 35 basis points is far from prudent. More so when a large part of the carry can be captured through the 5-year tenor.

One auction in the 10 years should be large enough to push the spread to 50 basis points.

The currency swaps saw a big move to the left as the rumours of an imminent yuan revaluation gained currency. We saw a reasonable amount of forward selling, which pushed the spot as well as the forwards lower. At the peak of the frenzy, we actually saw the one-year forward implied rupee yield move close to the reverse repo rate of five per cent.

It retraced from those levels on Friday on the back of a Chinese official's remarks, which seem to suggest that the revaluation might not happen too soon.

However, going ahead the market will continue to be jittery and prone to movements on the back of fresh rumours out of China.

Even if the revaluation happens, as long as there is no dollar shortage in India, forwards cannot stay below the repo rate for long.

Apart from making our exports marginally competitive, the Chinese revaluation does not do anything fundamental for the rupee strength.

So, forwards look like a pay on dips to me.

They may not be a pay at the current retraced levels but 10-15 basis points lower, they surely are.

(The author is a senior trader with HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Inflation holds the key — Next rate hike seen far away

Inflation, liquidity concerns hit bonds

ADB loan for tsunami relief in Kerala

South Indian Bank joins NFS network

Corpn Bank plans representative office in Dubai