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Economists at Capital Economics think investors are still overestimating the chances of a significant tightening of Indian monetary policy, and that this will help keep a lid on the country’s long-term bond yields and put some further downward pressure on the rupee.

The RBI should help limit any increases in the yields of Indian government bonds

“We don’t think the fall in the currency reflects investors losing confidence in Indian assets. We suspect it is due to a reassessment of the outlook for Indian monetary policy following this morning’s Reserve Bank of India (RBI) meeting, where the central bank reiterated its dovish view and announced a new programme of bond purchases. Since then, expectations for policy rate hikes have been dialled back somewhat, and long-term bond yields have fallen a bit as well.”

“With the RBI making it clear that it will look through any spike in inflation in the next few months, and virus-related restrictions possibly delaying the economic recovery a bit, we don’t think there is any reason to expect the central bank to increase its policy rate before the end of next year. In contrast, OIS pricing suggests that investors still anticipate ~100bp of policy tightening by then.”

“We expect yields to rise by less in India than in the US. We forecast the yield of 10-year Indian government bonds to rise by ~40bp to 6.50% by end-2022, compared with an increase of ~90bp in the 10-year US Treasury yield.”

“We expect the rupee to weaken against the dollar. But there are some countervailing factors that suggest to us that it won’t continue to fall as dramatically as it has lately. For one, India’s current account situation has improved significantly over the past few years which should render the rupee a bit more resilient to rising US yields than it has been in the past. And the Indian government’s balance sheet is in relatively good shape, suggesting that fiscal concerns are unlikely to prove a drag on the rupee as yields rise, in contrast with some other emerging markets.”  

“The upshot is that we forecast the rupee to decline only slightly to ~75/US$ by end-2022, compared with its current level of ~74.5.”