If you want to know the true picture of inflation or the interest rate outlook, swaps are the best bet. India’s overnight indexed swaps (OIS), an instrument to hedge the interest rate risk of bonds, have been ahead of the bond market in signaling policy rate hikes of late.
So what are the swap rates telling us now?
The one-year OIS has surged 120 basis points (bps) since the Reserve Bank of India (RBI) hiked its repo rate by 40 bps on May 4 and the five-year rate has jumped about 60 bps. One basis point is one-hundredth of a percentage point.
The rate is hovering around 6.25 percent while the five-year OIS is around 7.25 percent. The benchmark 10-year bond yield has risen by a measured 35 bps during the same period. Yields move in opposite direction to bond prices.
According to dealers, swaps are pricing in not less than 3 rate hikes in the current fiscal year. The repo rate by December is expected to be at least 5.15 percent which was the pre-pandemic level.
Soumyajit Niyogi, director of the core analytics group at India Ratings and Research expects the repo rate to be back to the pre-pandemic level by August. “The market has already been expecting 100 bps hike in say six months. After the out-of-turn rate hike, it is evident that the RBI is very serious about inflation now,” said Niyogi.
He believes that the central bank may not hike rates at the meeting next month. The RBI’s monetary policy committee is scheduled to meet four times in the rest of 2022.
Will the RBI hike 3 times, pulling the repo rate up by 100 bps?
Swaps have been a better gauge of interest rate hikes and when they have not been accurate, swaps have at least been a true reflection of the inflation situation.
In June last year, swaps surged in response to retail inflation crossing 6 percent in May. Bond yields had remained steady, partly lulled by the RBI’s purchases.
Coming back to the present, swaps had risen by 50-70 basis points before the RBI announced the out-of-turn of 40 bps in the repo rate on May 4. During the same period, the benchmark 10-year bond yield rose by 20 bps.
It is evident that the response of bonds to the rather hawkish tone of the RBI at the scheduled policy meet in April was more measured than that of swaps.
Government bonds are influenced by supply and demand dynamics as well as liquidity. The continued easy liquidity has kept bond yields from surging.
Long-term bond yields move based on the government’s bond supply and the willingness of the central bank to support buying. While the former hasn’t changed for the worse beyond the budget announcement, the RBI has become a less willing buyer. In short, bond yields have more than interest rate hikes to worry about.
Swaps, on the other hand, are more sensitive to policy rate moves. After all, they are the instrument to hedge against interest rate risks. The market is also deeper than the government securities market with foreign investors playing a more active role. But here is a small detail to be kept in mind. Given the high participation of foreign investors, swaps tend to also reflect the global trend in interest rates and inflation.
“Swaps are driven a lot by offshore positioning. Swaps are reflecting what is happening globally,” said Jayesh Mehta, India country treasurer for Bank of America.
Currently, most central banks are on a rate hike mode.
The US Federal Reserve has hiked its rate twice and other major central banks have begun to pull up their policy rates. All this is also getting reflected in the Indian OIS market to some extent.
The April retail inflation print is expected to be nasty with some economists expecting it to cross even 7 percent. It is likely that interest rate swaps may get it right this time too on rate hikes, especially if inflation significantly surprises on the upside.
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