Bond yields rise, rupee falls on US Federal Reserve policy and crude prices

The 'dot-plot' forecast of FOMC's median forecast suggested three rate hikes in 2022, revised up from one earlier

The rupee and benchmark bonds declined after the US Federal Reserve (US Fed) indicated on Thursday that rate hikes are imminent to tame high inflation, further pressured by international crude oil prices touching $90 a barrel.

The ‘dot-plot’ forecast of US Fed’s median forecast suggested three rate hikes in 2022, revised up from one earlier. The taper, or bond purchases, will continue even as the pace will decrease.

Global markets fell after this, including in India. The rupee closed at 75.07 to a dollar, amid intervention by the Reserve Bank of India (RBI). The currency had fallen to 75.25 a dollar, from its previous close of 74.79. The 10-year benchmark bond yield rose to close at 6.75 per cent, rising from its previous close of 6.66 per cent.

Crude oil prices crossing $90 a barrel threaten to widen India’s fiscal deficit for the current fiscal ahead of the Budget on February 1. A widening deficit, and rising inflation, will force the RBI to hike its rates sooner than expected. The consensus among analysts is that even if reverse repo rates rise now, the repo rate will probably go up only in the second half of the calendar year. However, aggressive rate hikes by the US Fed may force the RBI to quicken its rate hike cycle to maintain an interest rate differential and keep foreign portfolio money invested in India, analysts say.

“The RBI has to take a call at some time on the rewinding of liquidity and the US Fed’s long-term guidance could be taken as a template by the Monetary Policy Committee for consideration,” said Madan Sabnavis, chief economist of Bank of Baroda.

In a note ICICI Securities said it expects the Fed funds rate to reach 1.25 per cent by the end of 2022, from 0.25 per cent now.

India’s retail inflation, at 5.59 per cent in December, was still within the RBI’s comfort zone of 4 per cent with a band of plus or minus 2 per cent, but can rise to uncomfortable levels if oil prices firm up faster because of the tensions between Russia and Ukraine.

“We have high inflation and uncertain growth just like the USA. The market is demanding higher yields and the question is how long can the RBI hold on to the present stance?” Sabnavis said.

The rupee, meanwhile, is expected to lose further, even though the central bank is expected to intervene to cushion the fall. The RBI was seen selling dollars in the market through nationalised banks on Thursday morning.

“Dips in the USDINR pair if any should only be more of correction rather than a reversal. While the high oil prices are adding to the pressure on the rupee at the moment, even if things get better geopolitically and oil prices subside, the US dollar will have an upper hand as we move ahead; we may well be in on our way to witnessing 76 plus again,” said Imran Kazi, vice-president at currency consultancy firm Mecklai Financials.
 

The rupee’s current level is a good opportunity for exporters to start selling their dollars for the medium term of six months, said Anil Kumar Bhansali, head of treasury at Finrex Treasury Advisors.

After the US policy, the US 2-year short-term rates jumped to a 23-month high of 1.17 per cent, while the 10-years bond yields rose to 1.85 per cent — its yields were barely 1 per cent a year back. The forward rates will come under pressure due to the rise in short-term yields in the US market, noted IFA Global.

“The volatility in USD/INR has returned with a bang,” said Amit Pabari, managing director of CR Forex, adding the rupee could fall to 75.70 levels in the short term.

Analysts now expect the RBI to also raise its rates quicker than expected.

“The Reserve Bank of India (RBI) will conduct monetary policy primarily with domestic inflation in mind. But aggressive monetary tightening by the US Fed invariably puts pressure on emerging-economy central banks,” ICICI Securities said.

However, India is in a much better position now to weather global volatility. The country was current account surplus in FY21 and is expected to be in a slight deficit of 1 per cent of gross domestic product (GDP) in FY22, and 1.5 per cent of GDP in FY23. India’s foreign exchange reserves of $635 billion are also adequate, the brokerage noted.

State Bank of India Group Chief Economist Soumya Kanti Ghosh wrote in his research note that it is time for the RBI to start with a reverse repo hike in the February 9 MPC meeting.

“In any rate hike cycle, the financial markets actually do better as any material risk is factored in the prices,” Ghosh said, adding that the interbank call rates and other short-term rates being much higher than reverse repo rate indicates the stage is set “for a reverse repo normalisation.”