Iran war: OIS curve surges as crude oil rally fuels repo-rate hike bets

Sharp rise in OIS rates suggests markets are pricing in possible RBI rate hikes this year if elevated crude oil prices sustain inflationary pressures

Overnight indexed swap (OIS) rates climbed sharply across the curve in March amid an escalating war in West Asia, indicating that market participants are beginning to price in a shift from the “lower for longer” narrative towards the possibility of monetary policy tightening if crude oil prices remain elevated.

 

The one-year OIS rate, the most closely watched gauge of near-term interest rate expectations, is now pricing in at least two policy rate hikes of 25 basis points each during the current calendar year, beginning in August, market participants said. Since the start of the conflict late last month, the one-year OIS rate has risen by 36 basis points.

 

It climbed 23 basis points last week to 5.84 per cent, while the five-year OIS increased by 17 basis points to 6.39 per cent over the same period.

 

On Monday, the one-year OIS rate inched up by 1 basis point to 5.85 per cent, while the five-year OIS settled 4 basis points higher at 6.43 per cent.

 

In an OIS contract, two counterparties exchange a fixed rate for a floating rate linked to the overnight Mumbai Interbank Offered Rate (MIBOR). Because OIS rates are largely insulated from liquidity conditions or government bond supply, they primarily reflect expectations of future monetary policy actions. A rise in OIS rates therefore signals that markets anticipate higher policy rates ahead.

 

“The OIS curve is already discounting some rate hikes. Markets are factoring in at least two 25 basis-point increases from August onwards,” said a dealer at a primary dealership. “The assumption is that if the conflict persists and crude prices oil remain elevated, it could turn inflationary and force the central bank to tighten policy.”

 

Market participants said overseas investors have been active on the paying side of the swap market, reflecting expectations that higher oil prices could push up inflation and widen macroeconomic imbalances such as the current account deficit and the fiscal deficit. 

 

Madan Sabnavis, chief economist at Bank of Baroda, said the rise in OIS rates broadly reflects the market’s assessment that the easing cycle has likely ended. He said that while the relationship between OIS pricing and actual policy action is not exact, it generally captures the direction of interest rates.

 

“In the past, if we look at the relation between the OIS and what actually happens, it is not a one-to-one correspondence, but directionally it is right. The interest rates are going to go up. It may not be two rate hikes -- it could also be one -- but what is more important is that there will be no more rate cuts. That is the important message given the environment we are in,” he said.

 

Crude oil prices have risen sharply in recent weeks, trading above $100 per barrel on Monday compared with around $74 per barrel before the conflict began. Traders said that even if geopolitical tensions ease, crude remaining well above pre-conflict levels could sustain inflationary pressures and shape expectations of future policy tightening.

 

“Balance of risks may shift towards a policy rate hike rather than a pause or cut if energy prices stay elevated for long and/or global rates increase; but unlikely to see steep increases as in FY23,” a note from Standard Chartered Bank said.

 

At the same time, some participants said the Reserve Bank of India may wait for clearer signs of sustained inflation before tightening policy. Higher crude prices could also weigh on growth by widening the current account deficit and raising subsidy pressures, forcing the central bank to balance inflation risks against the impact on economic activity.

 

“The RBI can still wait and see how inflation evolves. It may not react immediately because this shock could also hurt growth, so the central bank will have to balance both inflation and growth risks,” said a senior executive at a primary dealership.

 

A sustained rise in crude prices could complicate India’s macroeconomic outlook, as the country imports more than 85 per cent of its oil requirements. A sharp increase in oil prices tends to widen the current account deficit and can also put pressure on the government’s fiscal arithmetic if it chooses to absorb part of the fuel price shock through lower excise duties or higher subsidies.

 

Market participants said these risks are now beginning to be reflected in interest rate expectations, even as the central bank may prefer to assess the persistence of the oil shock and its pass-through to core inflation before responding through policy action.

 

All eyes are now on the next monetary policy review scheduled for April 6-8, which may provide clearer signals on the direction of interest rates.