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India rates are under pressure from a weaker INR and higher oil prices and analysts at Nomura believe this combination is affecting market expectations on RBI monetary policy.

Key Quotes

“Indeed, a weaker INR and higher oil price have, in our opinion, increased the likelihood of a rate hike. The market may well be using the 2013 template when the RBI hiked rates and tightened liquidity to defend the currency. However, we remain skeptical that there will be aggressive monetary tightening in response to a weaker currency.”

“Unlike 2013, inflation is hovering at a very low level and this effectively means that India is operating at a high real rate cushion. Also, a weaker INR is a function of global factors rather than idiosyncratic factors. From that perspective, an aggressive stance on monetary policy may prove counter-productive to growth dynamics and may end up hurting growth-sensitive flows.”

“In the near term, we expect rates markets to remain under pressure as the correlation with INR is expected to stay high. That said, we are keenly watching the inflation trajectory and RBI’s stance to assess the impact on rates markets.”

“We believe a lower inflation trajectory and a relaxed stance on monetary policy may reduce the correlation over time. That said, we also believe that a reduced pace of depreciation could also lead to reduced correlation in bond markets.”

“Finally, we note that investors should keep an eye on liquidity dynamics in India. With India entering into a period of currency in circulation outflows, there is a need to infuse liquidity. This will likely result in the RBI conducting open market operation buybacks, which also have the potential to lower the correlation between rates and FX markets.”

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