RBI rate hike stumps markets; pause seen near

Reserve Bank of India (RBI) Governor Duvvuri Subbarao attends a monetary policy review meeting in Mumbai July 26, 2011.

MUMBAI (Reuters) - The BSE Sensex was slammed on Tuesday and the swap curve inverted sharply after the RBI stunned markets with a hefty rate increase, stoking expectations that policy rates may be reaching a peak.

The RBI raised interest rates by a higher-than-expected 50 basis points, stepping up its fight against persistently high inflation despite slowing growth in Asia's third-largest economy.

The one-year overnight indexed swap rate jumped as much as 26 basis points (bps) to 8.24 percent after the policy announcement, while the benchmark five-year swap rate rose 13 bps to 7.71 percent.

Nagaraj Kulkarni, a senior rates strategist at Standard Chartered Bank in Mumbai, despite the sharp inversion the shape of the OIS curve was hardly changed.

"So expectations that we are close to peak of rate-hiking cycle are intact," he said.

The rate increase was the 11th by the Reserve Bank of India (RBI) since March 2010, making the central bank one of the most aggressive to fight inflation.

However, Credit Suisse said in a note after the policy it expected the Reserve Bank of India (RBI) would raise rates by another 50 bps this year.

The main share index fell as much as 1.8 percent, with financials among the big losers after the rate decision.

"Investors are taken aback," said Neeraj Dewan, director of Quantum Securities from New Delhi. "The policy decision was totally unexpected. It will hurt credit offtake and economic growth."

The share benchmark is down 9.4 percent in the year to date as high inflation and hardening rates dent the outlook for corporate earnings.

"If the RBI is looking at sustained downtrend in core inflation before it takes a pause, then we have more actions left. In my view, the RBI should take a pause till November and wait to see the transmission impact of actions taken so far," said Nitesh Ranjan, economist with Union Bank of India.

OIS CURVE

The front-end of the OIS curve rose more sharply after rate move, pushing the 1-year rate up 31 bps on the day, and is set to post its biggest single-day rise since late October 2008, according to Thomson Reuters data.

The negative spread between the 1-year and 5-year OIS rates stands at 53 basis points from 42 basis points before the announcement. The swap curve had first inverted on May 27.

"We are expecting the 1-year OIS to move to 8.40 percent next month or so and the negative spread between 1- and 5-year will continue at these levels unless we see negative growth numbers," said Manoj Swain, chief executive officer at Morgan Stanley Primary Dealership.

The 10-year benchmark bond yield climbed as much as 11 bps to 8.43 percent post the policy, taking the rise to 14 bps on the day.

"The 10-year yield will move towards 8.50 percent over the next few weeks due to continuos debt supplies. Going forward it will be more data-dependent. The market is not pricing in any more rate hikes. The 1-year OIS would have been at 8.50 percent or higher otherwise." Morgan Stanley's Swain said.

(Additional reporting by Aditya Phatak and Ami Shah; Editing by Ranjit Gangadharan)