The five-year overnight indexed swap rate dropped to 6.04% on Thursday, its lowest level since April 7 2022, a time when the RBI had not even started raising policy rates.
The OIS market is seen as the clearest indicator of future policy action by market participants. A wider move in five-year swaps highlights the expectation of dovish actions in the medium term while the one-year swap rate stays elevated.
"Market is definitely looking at a rate cut before end of 2023. There is front-running for the same," said Vijay Sharma, senior executive vice president at PNB Gilts.
"Also, if the first cut does not come in October-December, there are hopes for a series of cuts whenever the cycle starts."
The swap rate has already crashed nearly 40 basis points (bps) since the beginning of 2023, prompting market participants to term this as the year of the policy pivot.
The sharp move in swaps comes after a decline in U.S. yields, as weak economic data and easing inflation has raised bets of a reversal of hikes before the end of this year.
The Fed Fund futures are pricing in a nearly 70% probability of rate cuts in November and December, with the rate ending 2023 in a 4.25%-4.50% band. The Fed is expected to raise rates in its next two meeting to the 4.75%-5.00% range.
"Every weak economic data increases confidence over a recession in the U.S. and rate cut bets," said Anuj Bhala, head of rates trading at SBM Bank (India). "Even if the RBI does not mirror the action, the view is that they will keep sufficient liquidity in the system, which will aid lower yields."
The RBI has been withdrawing pandemic-era banking system liquidity surplus, as it remains in the "withdrawal of accommodation" phase.
"Also, with the next year being an election year, growth needs to be pushed, which happens only when money is floating in the system. The RBI is likely to change its outlook towards liquidity management," Bhala added.
(Reporting by Dharamraj Dhutia; Editing by Janane Venkatraman)
By Dharamraj Dhutia
