The conflict in West Asia is beginning to reshape expectations in India's interest rate market. Traders in the overnight indexed swap market have started pricing in the possibility that the Reserve Bank of India could begin tightening monetary policy as early as in October with a stricter stance, as higher crude oil prices and global uncertainties cloud the inflation outlook.
Swap rates have risen sharply in recent weeks. The six-month OIS rate was last traded at 5.71%, which is 46 basis points above the RBI's repo rate of 5.25%, while the three-month contract traded at 5.50%, a premium of 25 bps.
In the most-traded short-term contract - the one-year swap - traders are paying fixed rates around 6.03%, reflecting expectations that borrowing costs could move higher over the coming months. The one-year swap rate was around the same levels after the RBI’s last monetary policy meeting, but had fallen to 5.72% on July 7 due to the then ceasefire between the US and Iran.
The move in swap rates reflects growing concerns that a prolonged conflict in West Asia could keep crude oil prices elevated, increasing India's import bill and stoking inflationary pressures.
Crude, which had fallen in June, saw a spike again last week, raising fears that headline inflation could climb beyond the RBI's comfort zone of 2-6% and trigger a policy response. Higher oil prices could also weigh on the rupee, strengthening the case for a tighter monetary policy. Brent crude is currently trading near $100 a barrel.
At the RBI's latest policy meeting, Governor Sanjay Malhotra said the central bank would closely monitor the impact of persistent geopolitical tensions and the monsoon on domestic price stability.
While the recent inflation print comforted the market at large, worries resurfaced as crude prices turned hot again. India's CPI accelerated to 4.38% in June from 3.93% in May. Even as headline inflation moved above the RBI's medium-term target of 4%, the market took comfort in core numbers.
"The June inflation print crossing the Reserve Bank of India's 4% medium-term target is a warning sign, but a single data point may not be enough to force the RBI's hand. If the CPI moves toward 5%, a rate hike becomes inevitable," a dealer at a private-sector bank said.
Most in the market expect the Monetary Policy Committee to leave the repo rate unchanged at its August meeting. However, several traders believe the RBI could shift its policy stance from "neutral" to "restrictive" by October, paving the way for a 25-basis-point rate hike in December.
Interestingly, the bets of a tighter policy outlook have not entered the government bond market. Instead, traders are using the OIS market to hedge against interest rate risks amid heightened uncertainty in global financial markets.
The other two risks are also driven by overseas factors. First, the US Federal Reserve's policy trajectory. Policymakers in the world’s largest economy are seen raising interest rates as early as September, a move that could give the RBI greater room to tighten policy without significantly affecting capital flows.
Second, foreign investment. A positive decision on India's inclusion in the Bloomberg Global Aggregate Index by the end of the month could attract an estimated $25 billion-$30 billion in foreign inflows, providing support to the rupee and easing pressure on the domestic central bank to raise rates. Traders said that if foreign investments turned positive in a consistent manner and other macroeconomic indicators remained supported, it could make a case for the central bank to keep the interest rate unchanged for a longer period.
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