Overnight indexed swap (OIS) rates, the principal tool for hedging interest rate risk in India, have climbed sharply since the RBI’s last policy in June and now suggest that the central bank would only lower the repo rate in August of next year as against the earlier pricing that pointed towards policy easing at the beginning of the next fiscal year.
A rise in OIS rates typically reflects market expectations of tighter financial conditions. In the current scenario, however, the hardening swap rates do not reflect views of rates being raised but rather are a repricing of earlier optimism about rate cuts.
Since the RBI’s last policy statement on June 8, rates on two of the most liquid OIS contracts – the one-year and five-year swaps – have jumped 14 and 20 basis points, respectively.
“Currently, OIS is suggesting no rate action till one year. It’s only somewhere around August (2024) that you get maybe one rate cut and then one more in the latter half of that fiscal year. The market doesn’t have a strong view on the easing cycle and that easing cycle will be shallow,” said Abhishek Upadhyay, senior economist at ICICI Securities Primary Dealership.
“Near-term sentiment is also playing a role. There was earlier an expectation of April rate cuts but that has now been repriced,” he said.
What has soured the near-term outlook is apprehension of the next domestic inflation print surging past the RBI’s tolerance band of 2-6% and a much more sober outlook on when the US may start trimming interest rates, given unexpectedly firm growth in the world’s largest economy.NEAR-TERM CAUTION
While the July CPI inflation print – due in early August – is not seen prompting the RBI to undertake further tightening, it effectively dampens chances of the central bank turning towards a softer policy anytime soon. The key culprits are food prices, with prices of certain items like tomatoes rising to levels that have prompted consumers to pare consumption of the commodity.
“Led by higher food prices, CPI inflation rose from 4.3% in May to 4.8% in June and threatens to come in at 6.5% in July. All eyes are on the soaring price of tomatoes, which rose 22% month on month, seasonally adjusted, in June, led partly by unseasonable weather,” HSBC’s economists Pranjul Bhandari and Aayushi Chaudhary wrote. They also flagged concerns over prices of rice, wheat, and cereals with a myriad of factors including floods, insufficient rains in south and east India and geopolitical factors like changes in the Black Sea grain deal posing upside inflation risks.
“Overall headline CPI inflation is expected to average at 5.4% in FY24 with Q2 inflation averaging at ~6%. The spike in vegetable prices is expected to be transient given the multiple harvest seasons and our estimate builds-in some reversal by September,” IDFC First Bank’s economist Gaura Sengupta wrote. The RBI’s forecast for CPI inflation for FY24 is 5.1%.
Another factor that has doused hopes of cost of funds heading south is the resilience shown by economic growth both in India and the US despite sharp monetary tightening. Earlier this week, the IMF raised its growth forecast for India, saying that domestic investment remained strong.
The US Fed may be nearing the end of its aggressive rate hike cycle but it is no longer seen swiftly turning towards rate cuts in the face of a faltering economy. Analysts no longer expect the Fed to lower rates in 2023. “While June (US) CPI was certainly welcome, it will probably take a few more favourable outcomes to influence the US FOMC’s thinking more meaningfully. While labour markets remain tight enough, we maintain that the economic lags of massive hikes will not necessarily require further hikes beyond July,” Madhavi Arora, economist at Emkay Global Financial said.