Higher short-term rates can translate into higher dollar/rupee premia

Earlier this month, the Monetary Policy Committee (MPC) surprised markets by changing the monetary stance from 'accommodative" to "neutral". Since then, the benchmark 10y bond yield has settled 40 bps higher than its level just before the policy announcement, and is at 6.85% currently.

Short-term yields have also moved up alongside, despite the surge in banking liquidity post the demonetisation exercise, and despite credit offtake printing historical lows of 5% for now. The following factors have put a floor on short-term yields. First, the likelihood of immediate interest rate cuts in India have all but disappeared. Second, RBI continues to mop up surplus banking liquidity at close to the repo rate of 6.25%, by way of ad-hoc short term reverse repos – rather than at the 5.75% lower end of the LAF corridor. Lastly, the MPC continues to reiterate its intent of eventually achieving neutral liquidity. RBI does have tools in its arsenal to accelerate the move to neutral liquidity.

The MPC's decision not to cut interest rates at its last meeting can be well justified under considerations of financial stability. After all, the world is an uncertain place now. While equity markets globally have risen with the expectation of President Trump reflating the US, there still are considerable global vulnerabilities across China, Europe, and populist trends. The differential between 10-year sovereign yields between India and the US have dropped from 6% in 2014, to 4.5% now. Whether the global economy heads for a boom, or a bust, or settles in-between, we can argue the case for caution on the domestic interest rate front.

However, one could equally argue the case to steepen the Indian interest rate curve – by letting short term rates remain low. We need the restart of the investment cycle in India, and in the current context post-demonetisation, we could even argue the need for a short term boost to consumption. At 5% banking credit growth for the past 5 weeks, neither of this seems imminent. Likewise, higher short term rates also translate into higher USDINR premia, and may increase unhedged currency exposures. The opportunity provided by the transient liquidity surplus to improve transmission to lower MCLR lending rates, and to reduce unhedged currency exposures, even temporarily, may be slipping by.

In the meantime, the message from the MPC is clear – they will look to achieve 4% CPI, they believe core CPI remains sticky, and they believe that caution on interest rates – even if demand and credit offtake prints look very low in the short run – will help control CPI.