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Restating risks from term premium
We have for months been indicating the combination of neutral rates and term premium taking the 10y G-sec to a ‘fair’ value of 7.25%. With higher underlying inflation, benchmark rate recalibration appears to have been hastened. Emergence of fiscal dominance in a tight savings environment has also pushed up global term premium faster than expected. These appear to be taking rates to levels we projected, but fresh risks are emerging in terms of shocks to inflation, as well as the concept of fiscal*. This states a structurally higher fiscal deficit to achieve balance. Were these to be achieved, risks on rates are higher
MPC minutes, FCNR closure, liquidity concerns, data push yields up
India rates were lower early on, with markets seeing the MPC meeting as further postponing rate hikes (not our view), despite continued geopolitical developments. Lower crude oil demand forecasts in the second week led yields lower still. The third week saw yields rise back with the RBI announcing an early end to the FCNR scheme, while MPC minutes were seen as hawkish (matching our view). The last week saw yields rise further on fears of liquidity measures, stronger than expected India GDP & IIP, and Jackson Hole comments of Fed chair Warsh seen as implying openness to hiking rates.
Rate recalibration hastened, term premium and fiscal* are risks
Inflation prints continue to show transmission of input shocks – our work shows a 4 month lag with 18% transmission of imported WPI. Adding fresh shocks from the Monsoon and global developments, we see the path to reaching 6% neutral as hastened. We have written about this many times, showing how global neutrals are transmitting to India. Mixed India GDP growth numbers forestall hikes above neutral for now, though risks do exist. However, there are greater risks from transmission of high global term premium to India, where domestic levels have been suppressed by heavy OMOs. There is also a larger question around the overall public sector borrowing need (or fiscal*) being higher, potentially indicating longer-term supply risks.
Our rate views so far have been base cases, but upside risks might be emerging
We have been pencilling in 75 bps rate hikes in OIS with steepening of term premium for months now. While conditions are finally beginning to approach this, there are risks developing. The first is to the inflation forecast, with potential pump price hikes, higher gold, food prices and telecom subscriptions. These can push our 4.7% FY28 inflation forecasts also to the upside, requiring rates to rise above neutral. Second, global term premium is likely to increase further, forcing India premia to increase just as increased fiscal spending is seen as more appropriate. We continue to see 7.25% on the 10y G-sec as fair, but the above factors could push these higher.
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