It appears that India’s bond investors are betting on the disappearance of interest rate risks on their investments in a year’s time, in contrast to everyone else worried about inflation and monetary policy tightening. Overnight indexed swaps, a hedge against interest rate risks, have flattened beyond the one-year tenure.
The gap between the one-year swap rate and the five-year rate has narrowed to a mere few basis points (bps) in the past one month. That is because five-year swaps have nosedived by 70 bps at a time when every other indicator is screaming more policy rate hikes. What gives?
Swaps are a leading indicator of where markets expect monetary policy to go and how fast it will reach there. For perspective, India’s swap rates were way ahead of other markets in predicting a faster tightening of monetary policy by the Reserve Bank of India (RBI) in response to hardening inflation. Swaps had climbed more than 70 bps before the RBI announced the surprise repo rate hike of 40 bps in May, beginning the cycle of rate increases. In other words, swaps had priced in more than one rate hike by the RBI even before other indicators could show a similar trend. The emerging hawkishness among global central banks was fuel enough for swaps to remain elevated since the start of 2022.
Now, swaps are running ahead of others again in predicting that the RBI would begin cutting policy rates just a year from now and the pace could be faster as growth concerns come back while inflation cools off.
Dovishness in the air
Ever since Jerome Powell, chairman of the US Federal Reserve, sounded a bit dovish in his comments after the policy meeting last week, most markets have scaled back their expectations of policy tightening there. With the US economy showing two consecutive quarters of contraction, markets now believe that the Fed would dial back on its aggression owing to recession concerns. Elsewhere, China’s economic troubles and its zero-Covid policy has also increased the odds for a global economic slowdown. This could have a tempering effect on inflation, according to economists. Reduced aggression from the Fed has also rekindled dollar inflows into India, allowing the rupee to recoup some losses. The domestic currency’s bounce back from 80 per dollar should have a salutary effect on inflation as it reduces the risk of imported price pressures.
What’s more, a bunch of indicators seem to suggest inflation could soon begin to abate. Global crude oil prices are down sharply from their record highs earlier this year. The same is the case with other commodities such as metals, bullion and even food. Supply chain disruptions have begun to slowly smooth out although the threat from China’s Covid infection rates continue to weigh.
Back home, a combination of fiscal measures, easing of supply-side pressures along with a favourable base effect have begun to show up in headline inflation. Consumer Price Index (CPI) inflation was down marginally in June and is expected to cool off in coming months. That said, it is still expected to average above 6 percent for the current year. “We maintain our FY23 CPI estimate of 6.5 percent with a downward bias (RBI: 6.7 percent),” analysts at Emkay Global Financial Services said in a note.
Economists now see the terminal repo rate to be between 6.25 percent and 6.75 percent on expectations that base effect would drag headline inflation down next year. “Assuming it is successful in taming the price rise, there is a case for the repo rate to settle between 6.25 percent and 6.75 percent—and then hope that the base effect kicks in next fiscal. Perhaps this is the reason—along with rising fears of recession—there has been a big fall in OIS rates,” analysts at Crisil Ltd wrote.
Early signs indicate that the swap market may get it right once more on monetary policy. But inflation is more volatile than before and the jury is still out on central banks taking it easy on price stability.
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