India: Deeper curve inversion to come

The Reserve Bank of India’s “monetary policy stance remains firmly anti-inflationary, recognising that, in the current circumstances, some short-run deceleration in growth may be unavoidable in bringing inflation under control.” We continue to believe that such a policy stance suggests an inversion of the NDOIS curve. We keep our 2s/5s NDOIS flattener position in place while further lowering the target to -15bp. We revise our stop to +10bp.

The text of the RBI statement effectively states that the central bank stands ready to tighten again (the next policy review is in less than six weeks, on 26 July). In spite of that unequivocal guidance, the front end of the NDOIS curve does not anticipate much tightening at all: 1y NDOIS at 8% only suggests persistently tight liquidity conditions over the next 12 months, not more rate hikes. We continue to think this to be a mistake: despite rising global growth concerns, it is still too early to position for a RBI pause.

The RBI’s preferred measure of ‘core’ inflation (non-food manufactured products inflation) jumped from 6.3% April to 7.3% in May, well above their indicated 4.0%-4.5% comfort zone for the thirteenth consecutive month. As today’s statement highlights, this “suggests more generalised inflationary pressures; rising wages and costs of service inputs are apparently being passed on by producers along the entire supply chain.” Meanwhile, global commodity prices have experienced only a shallow correction in recent weeks, and the fiscal subsidy adjustments that the RBI expected have not as yet been delivered. Together, these factors suggest considerable upside risk to inflation and endorse the RBI’s continuing hawkishness. We believe inflation expectations are unlikely to ease materially until the domestic economic slowdown is more deeply established.

Further along the yield curve, several variables play important roles. Slower economic growth expectations, both external as well as domestic, are depressing long term yields, even as higher funding costs and the growing threat of fiscal slippage hurt the demand:supply outlook for government bonds. For now, the former effect is overwhelming the latter, which is understandable because the bond issuance schedule is fixed until end-September, but a poor auction could yet trigger a sudden bout of hedging in OIS. However, for the near-term we expect the growth dynamic to continue to dominate, especially if European sovereign concerns deteriorate further.

Although we are tempted to position via outright payers at the front end of the NDOIS curve, we recognise that elevated global market uncertainty tends to exacerbate volatility. Instead, we find that NDOIS curve flatteners continue to offer the best balance of risk:reward in the current environment. For the reasons outlined above (and those we outlined in our original trade note dated May 3, 2011), we persist with our 2s/5s NDOIS flatteners (initiated at +33bp on 3-May; currently +2bp). We revise our target level lower to -15bp, and lower the stop at our initial target level of +10bp).