The Hindu Business Line : CRR rate hike timing takes markets by surprise

Ten-year sovereign yields went past 6.65 per cent behind fears of an imminent rate hike by the central bank. It was only after the RBI Governor Dr Reddy's remarks that there were few signs of demand driving up inflation and that almost all of it was due to supply side factors, did the market start to cool off.

Stable rates

The Finance Minister's remarks about interest rates remaining stable over the medium term gave further comfort that a rate hike was not on the cards at least for the time being. Rates came down by a good 60-70 basis points across the curve from their highs.

Liquidity, however, has been a bit of a concern since the unexpected spike in inflation. Both the Prime Minister as well as the Finance Minister had spoken about the liquidity overhang in the system and the need to address it.

In this backdrop, a CRR hike is not unexpected at all, but the timing is a bit unfortunate for the market.

After the inflation spike, I believed that the central bank may not actually hike rates but sooner than later remove Rs 20,000-25,000 crore of liquidity from the system through a combination of a hike in CRR and an increase in the MSB amount. This is what I had said in my last column too (August 16). My personal expectation was that the central bank would move on the CRR by the third week of August.

No immediate action on the CRR front coupled with only a Rs 20,000 crore increase in the outstanding MSB limit made the market believe that the central bank had other ideas.

Then came the announcement of the guidelines governing the transfer of securities to the Held to Maturity (HTM) book being relaxed. The fresh set of guidelines will enable banks to transfer large chunks of their bond holdings into the HTM book, thereby significantly reducing their future interest rate risk.

Significant step

The measure was quite a significant step in itself. It made the market believe that the central bank was unlikely to take any further steps to worsen market sentiment till such time as the transfers actually happened.

The market has a done a full circle in terms of interest rate expectations - - from the inflation spike, to aggressive liquidity tightening by the central bank and then to no monetary measures for the time being.

In the normal course, a fifty basis point hike in CRR with more than Rs 40,000 crore of excess liquidity in the system should not have caused a flutter. But given that it has come when the market least expected it, it is bound to cause more than a flutter. More so because the Rs 10,000 crore of auction supply has not been digested by the market yet.

Yields should climb up by 15-20 basis points to start with and then should drift lower over the next few days provided no further bad news hits the market.

Worst is over

The positives of this measure are that the worst is over and that the hike is only 50 basis points and not more.

From the remarks made by the RBI Governor and the Finance Minister, it seems quite unlikely that we shall see a rate hike over the next three months. The economic data out of the large economies of the world are at best moderate.

Though the Fed will most certainly hike rates by another 25 basis points in their forthcoming meeting on September 21, one wonders if it will continue doing so given that almost all the economic data out of the US has been below market consensus.

Inflation and inflationary expectations in these economies are well in control and far from the level of discomfort, which makes me believe that inflation in India should also start peaking out.

Although the headline WPI inflation is unlikely to go below 7.25 per cent this fiscal, it should not go much higher as well.

If the inflation does not jump significantly from the current level, we should not see any fresh set of monetary measures.

Borrowing schedule

Although the fresh set of MSB and borrowing calendars expected to come out in the last week of the month shall weigh on the market, I do not see it fall significantly from here.

In the absence of any fresh measures, we should see the ten-year sovereign yield stuck in a 5.75-6.25 range. The 5-year OIS should also not break the 6.00-6.25 range soon.

The MIFORs have been drifting lower behind a dip in the forwards. I think the rupee appreciation story has slowly started gaining currency again.

In this environment, if the MIFORs jump significantly on the back of the CRR hike news, they may be a good receive.

(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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