The RBI is widely expected to raise the benchmark repo rate (the rate at which RBI lends to the banking system) in the annual 2011-12 monetary policy review on the 26th of July 2011. The rate hike, if it happens will be the third in as many months, with the last hike implemented in June. Should one be worried about the rate hike or is it business as usual for the markets? How will the markets react after the hike? What will be the market reaction if there is no rate hike? Let us look at the market positioning before the policy and then try and predict market behavior after the rate hike.
Fixed income markets
The fixed income markets are pretty much indifferent to a 25bps rate hike. In fact the market positioning suggests a 25bps rate hike and no rate hike thereafter. Money market securities (less than one year maturity papers) yields have fallen since the last rate hike in mid June. Yields on 91-day treasury bills have fallen by 15bps while yields on one year bank CD’s (Certificate of Deposits) have fallen by 30bps over the last one month. Corporate bond yields in the five and ten year segments have fallen by 25bps since mid June. Ten year government bonds yields have more or less remained the same while five year OIS (Overnight Interest Rate Swaps) yields have come off by around 10bps.
The fixed income market will remain static if the RBI raises rates by 25bps, with a potential for a rally if RBI signals an end to the rate hikes. A hawkish RBI post rate hikes will push up yields by 15 to 20bps across the yield curve with the five year OIS being the most impacted as the spread at which is trading against the ten year government bond is at a negative 72bps.
A pause by the RBI in this policy review will bring down yields across the yield curve with five and ten year government bonds performing better than the corporate bonds and OIS.
The Bank Nifty, which is an indicator of RBI policies, has moved up by over 5% since mid June while the Nifty has moved up by over 2%. The outperformance of the Bank Nifty suggests that the market is not too worried by a 25bps rate hike. If the RBI hikes rates by 25bps and signals a pause, the Bank Nifty is likely to stay static with an upward bias. A pause by the RBI will spur a rally in the Bank Nifty while a rate hike with signs of more to come will bring down the Bank Nifty sharply.
The Indian Rupee (INR) has moved up by a percent against the US Dollar (USD) since the last policy in mid June. The INR does not show too much of worries of a 25bps rate hike. The Rupee will follow the pattern of bonds and equities and strengthen if the RBI hikes rates and indicates a pause. The reason the Rupee will strengthen on a rate hike with a pause is that it will give confidence to FII’s that the RBI is confident of a fall in inflation trajectory. A rate hike with signs of more to come will weaken the INR while a pause will lead to rally in the Rupee.