When the RBI first hiked rates by 25 basis points in June most analysts accepted it as a one-off event. When it was repeated in August, it was seen as a front-ending for the full year. Now traders and businesses are bracing for 2 more rate hikes with the first hike coming in October itself. What has changed in the interim?
Capital flow worries
There is almost a market consensus that the food inflation due to MSP will be compensated by the side-effects of a slowdown following the trade war. The bigger issue for the government will be capital flows. September has already seen $2 billion of risk-off outflows on expectations that the Fed may hike rates on September 26th. To keep the capital flows steady and the interest differential attractive, the RBI may have to signal a hawkish stance by hiking the rates by 25 bps in October itself.
Bigger worry is the rupee
In one month, the rupee first breached 69 and then 71 and is now close to 73. The RBI did offer some support at 73, but it is uncertain how long they will really persist. The RBI has a forex chest of less than $400 billion and that is just about enough to cover 9 months of imports. The leeway is quite limited at this point of time to use reserves. The other option of NRI deposits is hardly being discussed and the RBI thinking on this front is unclear. It looks like the government may not want to risk it at this stage. The only option left is to prop up the rupee by talking up the yields. 10 year benchmark yields are already at 8.15% and the only support the rupee will require is a 25 basis points rate hike plus a hawkish view from the RBI. That may push the benchmark yields closer to 8.5% but the rupee will find a bottom. What happens to bond values is another issue altogether! ©