RBI may take a cue from Fed's rate hike in December

The US Federal Reserve raised its policy rate by 75 bps to 3.75-4 per cent last week and RBI is likely to take a cue by raising its Repo rate during its forthcoming policy review. The RBI is expected to raise the repo rate to at least 6.5 per cent or higher as providing a currency defence becomes prominent on the RBI's agenda.

The RBI may increase its policy rates by 50 basis points next month. As per ICICI Direct, the CME Fed tool watch indicates a 61.5 per cent probability of a 50 bps rate hike in the December meeting. Not to mention, the RBI had maintained a stony silence during its recently concluded MPC meet.

This would largely keep global central banks on continued tightening path, and analysts do expect same in case of India too. A report by HDFC Bank Treasury Research expects that RBI will hike repo rate with 6.75 per cent as fulcrum terminal rate. Given the dollar strength and our current account deficit situation, analysts do not think RBI would lower its guard or pause earlier as that would create further speculative risks on Indian rupee.

Given that RBI has missed the inflation target zone for three consecutive quarters and law requiring RBI to provide explanation to the government, experts think RBI will not keep even tighter vigil. Hence, tightening policy to levels where it is sure of meeting inflation targets and not pause prematurely on hope.

In fact, analysts see yields hardening by 15-25 bps over period of next couple of months. The yield curve is expected to remain flattish in the move. This would mean some possible MTM impact on investors in near-term however, it will also provide better accruals to existing and new investors once the yield move up.

While raising the rate, the Federal Reserve signalled that it might dial down the pace of rate increases, perhaps as early as December, however the terminal rate is likely to be higher than earlier expected.

Interestingly, while one expects the RBI to continue with its FX interventions to stall free falls in the rupee, it is unlikely to defend any specific levels. On the liquidity front, conditions are likely to remain tight (with brief periods of liquidity slipping into deficit) and any injection of durable liquidity (beyond any measures under the LAF window including longer term repo operations) – that is viewed as 'accommodative' is likely to be difficult to deliver and to justify by the RBI. That said, there could be some natural supports for liquidity conditions as government spending picks up during the second half of the year.

The dollar bid remains intact in the near-term as the Fed policy announcement did not offer much good news for the markets, consequently, the path towards 83.50 or maybe even 84.0 for the USD/INR pair in the near-term remains in place.