India: RBI - Clearly hints at a pause

Key policy rate hiked further 25bp...
The Reserve Bank of India (RBI) raised the repo rate by another 25bp to 8.50%. This was its 13th hike since March 2010, which has seen the policy interest rate rise by a cumulative 525bp. The hike was in line with our expectations. We believe it would have been very difficult for the RBI to avoid announcing a 25bp hike when headline inflation is hovering around 10% y/y and core inflation is consistently above 7.5%. The RBI also re-iterated its anti-inflationary policy stance.

As expected, no changes were made to the cash reserve ratio (CRR) or statutory liquidity ratio (SLR), which remain at 6% and 24%, respectively. On the other hand, the RBI deregulated savings banks' interest rates with immediate effect. This change is likely to result in upward pressure on the deposit and interest rate trajectory in the near term given the ongoing tightness in liquidity.

...but virtually commits to a 'pause'
In today's policy action, while the central bank acted moderately hawkish as expected, it clearly guided for a "pause" hereafter.

In the RBI's own words:
"...notwithstanding current rates of inflation persisting till November (December release), the likelihood of a rate action in the December mid-quarter review is relatively low. Beyond that, if the inflation trajectory conforms to projections, further rate hikes may not be warranted. However, as always, actions will depend on evolving macroeconomic conditions."

The RBI also revised its FY 11-12 growth projection down to 7.6% (from 8%) while keeping its inflation forecast unchanged at 7% by March 2012.

Figure 1 below details our interpretation of various comments from India's central bank.

Market view

10y G-secs
We expect 10y G-secs to trade in a range of 8.65-8.90% in the near term as supply pressures continue. A respite will likely only come from RBI open market operations (OMOs) or increases in FII limits, in our view. Until announcements are made regarding either of these areas, we expect banks to remain hesitant to start buying bonds. The risks to this expected range are biased towards the downside and, we think, will depend on the timing of potential OMO announcements. However, we are constructive in the medium term as we expect the RBI to conduct ~INR1trn of OMOs to offset incremental tightness in liquidity. But given uncertainty over the timing of any announcement, we are cautious on bonds in the near term.

Liquidity and front-end rates
We expect banking system liquidity to remain tight over the next 3-6 months. Barring any injections by the RBI, we continue to expect changes in currency in circulation and CRR requirements to continue to drain total systemic liquidity (TSL = banking system liquidity plus government's cash surplus with the RBI).

The deregulation of savings bank rates will likely result in them seeking to attract more deposits from the public. However, we think the impact of this regulation change on overall liquidity will not be large. For instance, a 1% change in the growth rate of currency in circulation impacts our projections by INR100bn. This is relatively small compared with our base case of INR1trn being 'drained' by March 2012 (14% growth rate) through increased currency in circulation. In a 'worst-case' scenario of 11% currency demand growth, currency with the public would reduce liquidity by around INR700bn from current levels, which is enough for the call rate to continue to trade close the repo rate, in our view. Given this, we continue to expect the call rate average to be higher than the repo rate over the next six months.

We have been recommending paid positions in 1y OIS targeting 8.45% and with a stop-loss at 8.20%. The clear hint of a pause appears to have surprised the market and 1y OIS is currently trading at 8.10%. However, we view this as a knee-jerk reaction caused by stop-loss receiving, which is not warranted fundamentally. We think current levels will likely mark the near-term lows in 1y OIS.

Figure 1: Decoding the RBI's comments

Curve shape
We expect the curve to exhibit a bull-steepening bias from here rather than a bear steepening bias. This implies that any steepening at the front-end will likely be limited and is unlikely to beat carry costs until the RBI actually starts to cut rates. Note, 1y has an approximate carry + roll of 10bp/month. We think that 1x2 will likely stay flat while 2x5 will start to exhibit a steepening trend. Currently, 2x5 is trading at -20bp (mid) and we would suggest positioning for a move towards +10bp in the next two months. However, this trade would have a negative carry + roll of 3bp per month. To negate the negative carry on the steepener position and the given the low level of 1y (in our view), we suggest investors pay 1y OIS for half the duration risk.