US banking crisis: Key interest rates suggest RBI may go slow on tightening

The crisis in the US banking sector, triggered by the collapse of Silicon Valley Bank (SVB), has had a knock-on effect on a key domestic interest rate metric. This, apparently, suggests a less aggressive future quantum of tightening by the Reserve Bank of India (RBI).

Overnight indexed swap (OIS) rates, which are the primary instruments for hedging interest rate risk in India, have plummeted by around 34 basis points (bps) since March 9. This was when the turmoil in the US banking sector started unfolding.

The two most-liquid OIS products — the one-year and five-year swaps — have fallen 33 and 34 bps, respectively, since March 9. The one-year OIS was last at 6.76 per cent, while the five-year swap was at 6.33 per cent.

The fall in OIS rates mirrored a decline in the 10-year US bond yield, which plunged close to 40 bps after the collapse of SVB.

When OIS rates fall, market participants expect easier financial conditions. A rise in swap rates typically points towards tighter financial conditions and rate hikes.

The Indian OIS market is influenced by movements in US bond yields due to heavy market positioning from foreign entities. And, the latest decline in swap rates reflects hope of the RBI signalling a slower pace of tightening, traders said.

At the current level, the one-year OIS suggests that the RBI may raise the repo rate by 25 bps to 6.75 per cent, with some traders even betting on a pause in rate hikes.

 Prior to the recent slide, the one-year swap was reflecting a repo rate of around 6.85 per cent, implying room for a 35-bps rate hike by the RBI.

Swap traders pointed out that a key upcoming event — the Federal Reserve’s next monetary policy statement on March 22 could play a major role in determining the domestic rate outlook and correspondingly the course of OIS rates.

The US banking crisis, which to some extent was a consequence of the steep rate hikes by the Fed, is posing risks to financial stability. And, the American central bank is widely expected to opt for a much less aggressive path.

If the Fed were to hold off on raising rates, it would increase the chances of RBI doing the same, traders said. The RBI’s next policy statement is on April 6.

The RBI maintains that domestic monetary policy is determined by inflation and growth considerations at home. Traders said that a slower pace of Fed rate hikes would reduce the pressure on the RBI to maintain rate differentials with the US. The rate differential plays a key role in determining overseas investment into India. A faster pace of rate hikes by the Fed than the RBI, as has been the case since last year, narrows the differential. This reduces the appeal of domestic assets for international investors.

“The contagion has hit the underbelly of Fed... For the Indian context, we believe the bias of the markets siding with pre-fabricated rate rise numbers needs to be jinxed, by taking much smaller hikes of say, 10/15 bps, if at all. This should augur well for the markets,” State Bank of India’s group chief economic advisor Soumya Kanti Ghosh recently wrote.

Even from the perspective of domestic inflation, some analysts believe that conditions warrant a pause from the RBI, which has hiked the repo rate by 250 bps since May 2022.