When You (And Everyone Else) Expect Interest Rates To Rise: IDFC AMC

IDFC AMC Report

The last few weeks have been notable from a global rates environment standpoint, particularly in developed markets. Markets across many such geographies have brought forward their expectations for interest rate hikes, as unprecedented supply side shortages (including energy shocks) meet equally unprecedented fiscal stimuli in some of these economies, thereby challenging the ‘transitory’ narrative on inflation.

Developed markets, at least in the near term, are facing the kind of inflation one normally associates with their developing counterparts. Front end rates, which are most susceptible to interest rate hike expectations, have risen sharply in many geographies over the past month; more than doubling in some cases over this relatively brief span.

A notable aspect of this phase has been the fall in long term yields and the consequent flattening of the yield curve in many such places. In the U.S. for example, the gap between 30-year and 5-year government bond yields has less than halved from what it was in early May of this year.

This seems to be the market’s warning that even as it expects the Fed to start normalising sooner than earlier expected (market is now pricing in 2 rate hikes next year, on the heels of the completion of the so called taper program), it has if anything brought down its expectation of peak rates in this cycle. This is possibly on the back of evolving views on longer term trend growth rates, which in turn could be on a re-assessment of the durability of growth multipliers from the stimulus, the longer than expected squeeze on the supply side, the evolving Chinese policy priorities and associated lower expected growth rates there, and expected relatively tighter financial conditions over the next couple of years than before.

There may also be ‘technical’ factors in play here, so that the extent of flattening may be getting exaggerating.

However, the underlying message as summarised here may still hold relevance.

India also hasn’t been able to escape these global disruptions. However, with the government bond supply for the second half of the year being much better controlled and due to the global nature of this sell-off, the brunt has been felt by the swap curve. Across tenors (1 – 5 years) swap rates have risen by a very notable 50 bps or so since mid-September. And this after the October policy not yielding to the hawkish end of expectations and with RBI leadership (Governor and Deputy Governor) not deviating much from the previous script in the subsequent policy minutes as well.

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