The Indian Rupee (INR) is trading at record lows of Rs 60.73 to the USD. Government bond yields rose to its highest levels in 45 days on the back of the weakening INR. Bond yields have risen by 50bps from lows seen over the last one month, tracking the INR that has depreciated by 10%. Bond markets are taking out rate cut expectations from yields as the RBI has indicated that INR volatility will be a strong factor in policy decisions.
The bond markets taking out rate cut expectations is understandable given the current market environment but the market starting to fear rate hikes is another animal all together. The latter will be a death knell for the INR, bond yields, Sensex and Nifty and economic growth. The INR can easily touch Rs 70 to the USD while ten year government bond yields can rise by well over 100bps. Sensex and Nifty can fall to two year lows while India’s economic growth will come off to below 5% levels, growth levels last seen in fiscal 2002-03.
The reason a rate hike can cause damage to the markets is that the fear of a prolonged economic slowdown will gain hold of the markets. India’s GDP growth has come off from levels of 8.4% seen in 2010-11 to levels of 5% in 2012-13. The Indian government is fiscally constrained to push up growth as it is focused on bringing down the fiscal deficit to levels of 4% of GDP from levels of 4.9% of GDP seen in fiscal 2012-13.
RBI has had a bit of leeway in lowering policy rates from 8.5% to 7.25% over the last fourteen months as inflation has trended down. Inflation as measured by the WPI (Wholesale Price Index) has come off from levels of over 9% to below 5% levels over the last couple of years. Rate cuts by the RBI and lower fiscal deficit commitment by the government has brought down the ten year bond yield by 100bps over the last one year.
Economic growth revival has some hope when interest rates come off in the economy. The weakness in the INR is a natural consequence of falling economic growth and the only way the INR can strengthen is when growth picks up. Growth picking up is dependent of low interest rates when business and investment sentiment is weak.
A rate hike will not help the INR. The belief that interest rate spreads will rise between US treasury yields and INR bond yields will bring in FII flows is a fallacy. FII’s will consider many factors when looking to invest in INR bonds and these include cost of hedging the currency and the credit risk. A rate hike will only increase cost of hedging the currency risk as the INR will go into a free fall on the back of plunging GDP growth expectations. Credit risk on Indian credit will rise sharply on a weakening economy.
RBI is aware of the damage it can cause if it uses interest rates to stem a weakening currency. Rate cuts are highly unlikely to stem the INR fall and markets should not start to factor in rate hikes.