The interest rate market and economists are on the same page: both expect Reserve Bank of India to tighten policy rates eight days from now in its preferred ?baby step? style.?The narrowing of 1-over-5-year OIS, or overnight index swap, spreads over the past month suggests the market will take a 25-basis point increase in RBI?s overnight policy rate in its stride.?
And that the hike is expected to come amid cash squeeze.?Increases in the repo tender rate (on RBI?s loans to banks) and reverse repo rate (on borrowings from banks) are expected in the central bank?s first-ever mid-quarter monetary policy review on September 16. Normally, the hike in the policy overnight rate should impact the longer end of the yield more ? and that would have widened the spread. This time, it has narrowed because the hike is expected amid the tightening, which will occur due to tax payments on the eve of the policy day.
Tight cash conditions will hit the shorter end more.??The 5-year swap may move up by a maximum of 10 bps if the RBI hikes policy rates by 25 bps,? said Ashish Vaidya, head of fixed income at Union Bank of Switzerland.?Tuesday, the 5-year swap ended at 6.94% compared with 6.98% previously, while the 1-year was unchanged at 6.13%.?
The spread narrowed overnight to 81 bps from 85 bps previously. A month ago, the spread was 102 bps. On August 5, the 5-year reached its 22-month high of 7.42% as the market expected RBI to hike policy rates aggressively after inflation topped 10% again. A 50 bps hike was priced into the OIS rate instead of 25 bps expected before the new data.?
In the last couple of weeks, it has eased because new data of slowing inflation along with slowing industrial growth is expected to force RBI to abandon the pursuit of tightening more harshly than it has in the past.??The market feels that rates may not be hiked aggressively so as not to choke out growth,? said a Barclays Bank dealer. So the market is back to factoring in a 25 bps, or a baby-sized hike, as RBI has mostly done this year. The data on slowing growth has also led the market to believe that the September 16 hike may mark the last in the cycle.?
Rates have been hiked four times between March and July. On three occasions, both repo and reverse repo rates were each increased by 25 bps; on the fourth, on July 27, repo was hiked by 25 bps again but reverse repo by 50 bps.?
As the hikes could come amid squeeze on banks? liquidity due to tax payments flowing out of the banking system to government?s treasury, the 1-year OIS will rise more and faster than the 5-year OIS, said the Barclays? dealer.??The swap curve may become flatter and move slightly higher from here (current position),? he said. It won?t be the first time RBI has hiked rates amid a liquidity squeeze this year–and the tightness helped the transmission of its desire to lift interest rates to dampen demand-side pressures on inflation.?
Hikes amid tightness came in two rounds in July, lifting swaps to near two year highs.?So the market is readying for a similar trend post-tax payment and the RBI mid-quarter policy moves.?The tax payment is expected to drain around Rs 40,000-50,000 crore from the banking system.?That is roughly four times the surplus liquidity banks on an average parked at RBI?s reverse repo window.
J Moses Harding of IndusInd Bank expects money won?t be as tight this month as it was in July-August. And hence, the spread may not narrow dramatically. ?I do not see the spread narrowing as liquidity would not be tight as it was earlier,? said Harding, who is head of global market at IndusInd Bank. He expects RBI to hike both rates (reverse and reverse repo) by 25 bps causing the whole swap curve to move upwards.