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Markets are now pricing in 5-6 rate hikes over the next 12 months: the 1Y OIS (average expected repo rate over the next 12 months) has climbed to 6.3%. Since 2010, this has correctly predicted all four hiking cycles, though it missed on magnitude twice. However, i) OIS began to rise on the day of the Iran conflict and may reverse if the Strait reopens; and ii) we expect several other options to be explored before rates are hiked to stabilize the INR. The step-jump in prices due to higher oil/weaker INR does not warrant monetary policy shifts; slack in the economy means inflation is not sticky. Sustained fiscal support can broaden these shocks into generalised inflation, but not immediately.
Markets expect rate hikes to start in less than six months; 5-6 hikes in a year
Overnight Index Swap rates (OIS) indicate market expectations of repo rates: e.g., the 12-month OIS is the expected average of daily repo rates over the next 12 months. Pre-war, the 12M OIS only expected the Dec-2025 rate cut to be reversed. But it has risen sharply since 28-Feb (start of Iran war) to 6.3%, implying 5-6 25bps hikes over the next 12 months. In the past, the 1Y OIS rate has been a reliable leading indicator of the direction of policy rates, though in two of four episodes the magnitude of hikes was ‘overstated’.
OIS spiked with Iran war; slack in economy means sticky inflation still unlikely
OIS rates have increased globally by varying levels after the Iran war broke out, due to the expected inflation from supply disruptions: higher energy prices and second order effects on other goods and services. In India, INR depreciation necessitated by the terms-of-trade shock also raises risk of imported inflation. Importantly for repo rates: i) OIS rise is directly tied to the Iran conflict (not yet due to adverse weather); and ii) these are step-jumps in prices (i.e., YoY inflation would fade after a year), whereas monetary policy needs to respond to sticky inflation, which is low given the slack in the Indian economy. That said, sustained fiscal support can broaden these shocks into generalised inflation.
Will history repeat? The answer remains in the oil markets
OIS markets have had ‘4-in-4’ predictive success since 2010, and the two episodes where hikes were lower than OIS-predicted had idiosyncratic factors: i) In the 2013-14 taper tantrum, repo was not the target rate, and WACR did peak close to 1Y OIS; ii) In 2018 hikes were despite low inflation but triggered by ~15% INR depreciation (a policy error, in our view). History, thus, suggests a high likelihood of a 50bps hike in the next 12 months. However, we expect 1Y OIS to reset lower if the Strait of Hormuz reopens and oil markets ease in the next few months. A rate hike to stabilize the INR, we believe comes very late in the list of options available to address the dollar liquidity problem stressing INR currently. Better options include raising fuel prices further and cutting taxes on FPI debt.
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