'See rupee trading in the range of 72.50 to 74.50 in the short term'

The nationalised banks have been relentlessly paying forwards on behalf of the Reserve Bank of India (RBI). On its part, the RBI has been buying US dollar (USD) in the spot market and sterilising the liquidity infused as a result by swapping the USD forward, i.e. doing a Sell-Buy Swap.

Nationalised banks have also been receiving the near-end of the forward curve for their own asset liability management (ALM) purposes. Receiving in the near-term and paying in the far has resulted in the curve becoming very steep. While the 3-month premium has gone up from 3.6% to 3.90% over the last three weeks, 1-year has moved up from 3.85% to 4.35%.

TABLE:: This is how the curve looks currently

1m 3.75%

3m 3.90%

1y 4.33%

2y 4.46%

3y 4.97%

4y 5.44%

5y 5.73%

Receiving longer tenor, therefore, looks a good proposition considering the steepness of the curve. Near-end is likely to remain anchored on account of abundant Rupee liquidity in the banking system. 3-month T-bill cut offs (most recently 3.23%) have been coming in below the Reverse repo rate (3.35%) even when a rate cut in October looks unlikely at this point.

Mutual funds, on the other hand, have been big buyers of T-bills. While the 3-month T-bill is at 3.23%, 10-year GSec yield is at 6.20%. The GSec Curve, too, therefore is equally steep. The steepness there is on account of reluctance among market participants to hold duration after higher consumer price inflation (CPI), hawkish monetary policy committee (MPC) minutes and delayed announcement of open market operation (OMO), or 'Operation Twist', by the RBI.

The government and markets, too, seem to be drawing comfort from RBI governor's recent remarks that the RBI would ensure that the government borrowing goes through in a non disruptive manner. Market is taking it as an implicit sign that the central bank would eventually announce further OMO/OMO twists to absorb the supply. Despite the Rs 18,000 crore devolvement of benchmark security on Primary Dealers (PDs) in most recent GSec auction, the bonds rallied post the auction. Though devolvement is usually negative for bond markets, in this case, ensuring non-disruptive borrowing would require further devolvements not taking place and that would require RBI to step in. PDs, too, therefore, would be relying on RBI intervention and therefore are not desperately dumping the stock in the secondary market as OMOs would offer them a better exit.

From its recent actions in bond markets and forex (FX), it seems the RBI is not keen on infusing further liquidity into the banking system. That explains the aggressive sterilisation and announcement of an OMO twist rather than an outright OMO. However, considering that a steeper curve would impede monetary policy transmission, the RBI may not want to see it steepen further. We expect both the forward curve as well as the GSec curve to flatten from here on.

What surprises also is the lack of flexibility in spreading issuances across the curve where they may see higher demand. At a time when the market is averse to holding duration, the notion that a liquid on the run benchmark security would definitely find takers is faulty one. Spreading issuances would make absorbing supply easier. For example life insurance companies or EPFO could mop up issuances in the longer end and banks and MFs may be more comfortable buying bonds of shorter duration.

So, where does all this leave the rupee, which rose to its highest level against the US dollar in around six months on Friday?

While the central bank has been relentlessly absorbing inflows to shore up it's reserves, we are seeing a trend where the central bank, once in a while, steps away from bids to shatter market complacency. We had last seen this happen on July 2, 2020 when the RBI stepped aside and let 75.40 level on the rupee break, a level which it had so aggressively been defending until then.

We are now witnessing a similar trend with the rupee breaking 74.50 levels against the USD, mainly on account of nationalised banks being absent from bids on behalf of the central bank. As a result, we expect the USD/INR pair to trade in the range of 72.50 – 74.50 in the short-term.

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The author is CEO of IFA Global. Views are his own.