India: Rates pricing in cuts, FX vulnerable to global cues

The turmoil in global markets is spilling over to the Indian asset markets, adding to domestic concerns.
Radhika Rao06 Aug 2019
  • A weakening CNY bodes poorly for the Indian rupee
  • INR bond yields are relatively stable, caught between a weak INR and low US yields
  • Of the 50bp cuts we expect in rest of FY20, 25bp reduction is likely this week
  • The RBI will look beyond policy decisions, as we noted in an OpEd
  • News on the sovereign bond is under watch, with a delay to be negative for rates
Photo credit: AFP Photo

Risk-appetite took a knock in overnight trade, as trade and currency conflicts continue to escalate. The latest salvo was the US Treasury department labelling China a currency manipulator after the CNY depreciated past 7 against the US dollar on Monday (see Macro Strategy dated Aug 6, 2019 for details).

The turmoil in global markets is spilling over to the Indian asset markets, adding to domestic concerns. For the INR, the US dollar trend, CNY direction and flows matter more. As the chart shows, the rupee and yuan have moved closely this year, particularly during bouts of weakness.

This puts the rupee at risk of further depreciation. On the broader USD, we retain our long-held view that the positive rate and growth differentials will continue to support the USD this year, as growth risks are starker in the EU/ Japan.

In addition to USD and CNY, domestic flows will also be key for the INR. Portfolio (~USD13bn YTD) and trade flows (narrower deficit since year ago) have been positive, providing some cushion to the rupee at the margin. Oil prices sliding on global growth concerns is favourable for the trade balance. Our FX Strategist maintains his call for the INR to gradually weaken this year.

In contrast, INR bond yields are relatively stable, caught between a weak currency and a sharp decline in US yields. Our suggested range of 6.30-6.45% for the 10Y bond yields held in the past week. An under-pressure rupee could hurt the appetite of debt portfolio investors, as reflected in outflows in August yet far.

But this is being offset by US yields that have declined sharply, as an escalation in the trade conflicts trigger growth worries, spurring expectations of further policy easing from the US Fed. The next chart highlights that past episodes of a decline in global/ US yields have also held down INR yields. In this environment and with the Indian central bank likely to cut rates further, we don’t expect INR 10Y yields to return to 6.8-7% levels for the time being, despite risk aversion.

We continue to watch progress on the offshore sovereign bond. There is still lack of clarity on the issuance, but an outright delay beyond FY20 might hurt INR bonds as it would be perceived as negative for demand conditions. Yields are likely to be 5-10bp higher in the near-term.

RBI expected to cut rates on Wednesday

Of the 50bp more cuts we expect in FY20, the RBI-led monetary policy committee is likely to cut by 25bp on Wednesday. Markets have already priced this in, with further gains in 10Y bond yields hinging on RBI’s dovish guidance along with a liquidity framework (if announced) that signals a surplus balance stance.

Besides monetary policy, there are other things weighing on the central bank’s mind (see our Opinion piece on here). Foremost is to ensure that policy easing matters to borrowing costs. Banks’ six-month to one-year lending rates are lower by an average of 5-15 bps since the start of 2019, a fraction of repo rate cuts. The country’s largest bank recently announced cuts in time deposit rates, which is expected to help lower loan rates down the line. Sharper cuts are, however, a challenge as cutting deposit rates further will require returns on national small saving to also fall meaningfully.

Few means by which transmission can be accelerated:

• Dovish guidance to suggest further easing is likely to defend against growth risks from a weak monsoon, soft consumption and tight financial conditions. 1QFY20 growth is likely to be sub-6% for the second consecutive quarter

• Liquidity stance will be key. Prevailing conditions are already in surplus (of INR1-2trn) and have been maintained such, suggesting an unofficial shift in stance. Intuitively, surplus liquidity during a rate cutting cycle and vice versa during rate hikes helps with transmission

• Plans to link lending rates to external benchmarks, in a bid to expedite the transmission process, was deferred at the April rate review

In the interim, extent of transmission will rely on the respective banks’ balance sheet strength, deposits size, and anticipated duration of the rate-cutting cycle. Transmission has been better in the bond markets though that arguably is less beneficial to stakeholders’ vs banks’ lending rates.

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Radhika Rao

Economist – India, Thailand & Eurozone


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