RBI's short-term rate cut spurs bond market rally

The government bonds rallied on Tuesday after the Reserve bank of India (RBI) cut a short-term interest rate, betting that conditions are stable enough to unwind more extraordinary measures taken in July to defend the rupee, which hit a low just over a month ago.

The RBI move late on Monday to cut the marginal standing facility (MSF) rate by half a percentage point to 9 percent follows a 75 basis point cut in the rate last month by new RBI Governor Raghuram Rajan.

Benchmark 10-year bond yields dropped as much as 23 basis points at one point, while overnight index swap rates also plunged. The rupee closed largely unchanged.

Some analysts warn the move is risky. Although the Federal Reserve's decision last month to delay the tapering of its bond stimulus was a temporary reprieve for capital importing countries, strong growth numbers in the U.S. could see the Fed reduce its stimulus and instability reappear in emerging markets.

Although the reduction in the MSF, a short-term rate that banks use to borrow funds, is meant to be another step towards normalising monetary policy, it also contributes to uncertainty about the timing of future moves from the RBI.

The RBI is widely expected to continue cutting the MSF while raising India's main interest rate, the repo rate, by an additional 25 basis points this calendar year after its 25 bps hike last month.

"It's far too premature to believe that the rupee's travails are completely over," J.P.Morgan analysts said in a note to clients on Tuesday.

"Like other emerging markets, India has been the beneficiary of an improving global environment," they noted. "But globally things can often turn on a dime."

The rupee has rallied more than 11 percent since hitting a record low of 68.85 against the dollar on August 28.

Domestic factors have also played a key role in the rebound, including an improving current account deficit outlook, as well as other measures taken by the central bank such as providing a separate window to provide dollars directly to oil companies and measures to attract funds from non-resident Indians.

With Monday's move, the central bank has reduced the MSF rate by a total 125 basis points over the last three weeks after hiking it by 200 bps in mid-July in a bid to curb speculative trading by making short-term borrowing prohibitively expensive.

That move, the most dramatic in a package of measures to defend the currency, saw the MSF rate replace the repo rate as India's de facto policy rate.

Rajan, who took charge over as central bank governor on September 4, said at the policy review on September 20 that the corridor between the repo rate and the MSF would be gradually brought back to 100 bps. It currently stands at 150 bps.

The surprise timing of the move adds uncertainty about how the RBI will bring down MSF rates and raise the repo rate at a time when market participants are already debating the degree the RBI's tightening bias.

For now, analysts say the RBI would be unlikely to raise the MSF rate again in case it renewed instability in the rupee, given the confusing signal it would send about monetary policy aims.

"This is unlikely to be an aggressive policy tightening cycle," said Radhika Rao, economist at DBS in Singapore.

"The RBI is unlikely to resurrect the liquidity measures even if there is another round of rupee volatility. The July moves were largely ineffective in providing outright support to the currency, so by raising the repo rate RBI is also addressing the rate differentials deficit," she added.

Separately, the finance minister said on Monday the government will have to rein in spending and cut subsidies to meet its fiscal deficit target, underlining that an austerity drive will not be blown off course by an election due next year.

The comments, though positive, were overshadowed by the central bank's measures.

The benchmark 10-year bond yield ended down 18 bps at 8.50 percent, although the yield remains up nearly 100 bps since before the mid-July measures.

The one-year overnight indexed swap rate plunged 24 bps to 8.40 percent while the five-year rate closed down 15 bps at 8.11 percent.

Copyright: Thomson Reuters 2013