Interest rate swaps may post marginal gains

Ample liquidity and steady bond yields could ensure a modest rise in the OIS rates

Interest rate swap rates may post only modest gains in the coming weeks although hike in local interest rates seem certain after the US Federal Reserve hinted at continuing its campaign to raise interest rates. Swaps may, at most, rise by 5-10 basis points despite a quarter percentage point hike seen in the reverse repo rate in October.

"We see a rising trend in swap rates," said Arvind Sampath, vice-president at ICICI Securities. "Rate hike expectations in October will start building up and overnight indexed swaps (OIS) will reflect that view."

However, swap rates are not expected to shoot up because ample liquidity in the banking system and steady government bond yields could ensure that rise in the OIS rates will only be modest, dealers said.

On July 26, when Reserve Bank of India had left interest rates unchanged, the 5-year OIS had fallen by almost 25 basis points over previous close. But since then rates have remained stable-to-firm as crude oil prices surged and because in October a hike in the rate is expected.

"A week back, the 5-year OIS was at 6.23 per cent," Sampath said. "Now, it is at 6.25 per cent. So, they have already gone up." "OIS is a function of the bond market for the 3-year above segments and liquidity for less than 3-years," a senior dealer at a US bank said.

"Currently, OIS is caught between rates going up and the good liquidity situation. The sell-off in the bond market is also muted," he added. The most tracked 5-year OIS rate is expected to rise to 6.30 per cent by October 25when RBI releases its mid-year Annual Policy review""from 6.24-6.26 per cent currently, dealers and analysts said.

The hawkish stance of the US Federal Reserve could prompt the central bank to hike rates here. Tuesday, the Fed said the economic impact following the destruction by Hurricane Katrina will be felt only in the near-term.

The Fed indicated that its "measured" rate stance, meaning a sustained quarter percentage point hike in rates, would continue. For the 11th straight time since it started hiking rates in June 2004, the Fed raised its target funds rate to 3.75 per cent. With the Fed maintaining its hawkish stance, expectations are the rates would rise to 4.00-4.25 per cent by December.

"Swap rates will remain bid till the credit policy," the senior dealer at the US bank said. "And if oil prices continue the way they are, we do not see the bids coming off."

The RBI is expected to hike its reverse repo rate to contain inflationary pressures that may emerge from the persisting high domestic liquidity and firm international oil prices.

Headline inflation is expected to rise because the benefit of a high base, which had kept the rate soft in recent months, is set to wear off.

"For Mifor swaps, a lot depends on how the forwards and spot rupee will move in the short run," Sampath said. "But these (Mifor) too are looking up as, both, US yields as well as the dollar are seen strengthening after the Fed's rate stance yesterday."

Continuous rate hikes in the US have been supporting the dollar against leading as well as Asian currencies. Further rate increases could be a significant boost to the dollar and lift dollar yields in the coming weeks. But even as the dollar has been gaining, its impact on the rupee has been subdued, mainly because of the deluge of foreign institutional investor inflows into the country over the past few months.

Going forward, however, there are questions over the strength of such inflows. "As far as FII inflows are concerned, they have been good so far in spite of rising Fed funds rate," Rajani Sinha, analyst at JM Morgan Stanley said.

"While the global risk appetite remains high, it is getting increasingly difficult to predict for how long such high FII inflows could be sustained." In case of a reduction in FII inflows, the liquidity scenario could fall from plenty to scanty, Sinha added.

This factor is expected to weigh on the rupee in the coming months as even a slight reversal of the inflows could lead to a fall in the rupee. This was reflected today, when a 200-point fall in local share indices weakened the rupee to 43.92 per $1 from Rs 43.87 on Tuesday.

Also, a rise in cash dollar supplies has lifted forward premiums steadily. The near month forward tenures have gained significantly from the discounts at the start of the month.

"Forwards are definitely looking biddish as cash supplies have started coming in," the dealer at the US bank said, adding that MIFOR swaps should move higher by another 10-15 bps in the next few weeks.