Fall in US yield curve triggered RBI rate cut

Future interest rate reductions hinge on risk related to unwinding of dollar carry trade

One explanation for the Reserve Bank of India's surprise cut in its repo rate is in the falling yield in the US 10-year treasury bond, which was widening the arbitrage gap between yields in India and in dollar assets like this one.

This decline attracted foreign investors, to increase the carry trade in dollars to invest in India bonds. Dollar carry trade means borrowing in the dollar to invest in the rupee, as India offers higher returns even after discounting for hedging cost. Gross yield is still nearly six points higher.

In the three weeks beginning December 26, the US 10- year treasury bond yield declined from a peak of 2.26 to 1.86 per cent on January 14, a decline of 40 basis points (bps). During the same period, treasury yield of the 10-year bond in India fell from 7.98 to 7.77 per cent, a fall of 21 bps (1 bp is a hundredth of one per cent).

In this period, foreign institutions pumped an additional $1.27 billion in Indian debt. Since this is hot money, RBI had to shrink the arbitrage window and other fundamentals like inflation. The import bill being conducive for initiating a rate cut cycle, RBI cut the repo, seen as a surprise but not so for those tracking the gap between US and Indian treasury yields.

K N Dey, senior advisor, Mecklai Financial Services, said: “Changes in the US treasury yield curve will also be a crucial indicator for future rate cuts by RBI.” He cites an example of such development in mid-2013, when the rupee sharply depreciated against the dollar. In June 2013, the US 10-year treasury yield increased from 2.13 to 2.60 per cent, a sharp 43 bps. In that period, India’s rose from 7.23 to 7.46 per cent, a 23 bps rise, and this was when the trade and current account deficit was widening. In April-May ’13, the gold import bill was above $6 bn a month. Following these developments, in June 2013 alone, foreign institutions withdrew $5.37 bn from Indian bonds and the rupee fell 5.1 per cent in that month. The currency's slide started, which later further triggered a withdrawal of debt from the Indian market, as hedging cost was also rising sharply.

RBI didn't want to see more hot money, which could cause problems later as global markets were in a very volatile situation. In January, a day before the latest rate cut was announced, foreign institutions had already invested a net $1.27 bn in debt. If the rate would not have been reduced, hot money flow could have increased in India, ballooning the dollar carry trade. And, hence, the repo rate was cut. A 25 bps cut almost nullifies the difference between yield drop in both countries’ 10-year bonds and ensures the arbitrage margin doesn’t widen.

The reason for not opening the FII debt window further is also the risk of increasing hot money. Had the US yields had not fallen, the shrinking arbitrage gap and risk of reversal of debt was creating a dilemma for the RBI before the rate cut. A dilemma because the fundamentals were falling in place as favouring a rate cut. If RBI cut the rate and the US raised its, as is believed likely, there was the risk of a reverse flow.