A good monsoon and low inflation prompted the Reserve Bank of India to cut the repurchase (repo) rate by 50 basis points -- one basis point is one hundredth of a percentage point -- to 4.5 per cent.
Shrugging off the surprise, the market is now punting on a bank rate cut in the RBI's forthcoming credit policy in October.
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The repo rate is the rate at which banks lend to the RBI. The bank rate, the rate at which the RBI lends to banks, is pegged at 6 per cent.
"The RBI is now projecting a higher than 6-6.5 per cent growth. To support this, it may cut the bank rate to inject monetary stimulus for growth," said a banker who did not wish to be identified.
The repo rate cut, which takes effect from Monday, is set to drive down market rates of all instruments across maturities.
The yield on the 10-year benchmark paper fell from 5.58 per cent to 5.35 per cent on Saturday. This would come down further to around 5.25 per cent, dealers said.
At the shorter end, both the 91-day and 364-day treasury bill yields are likely to come down by 30-35 basis points to around 4.65 per cent.
"The repo rate cut, though unexpected, will act as a trigger for lowering interest rates for the time being. However, the rates can go up by the end of the year if there is tightness in liquidity. For the time being, the 10-year yield will veer around 5.25 per cent," said a bond dealer with a foreign bank that runs an active treasury.
By October, the 10-year paper yield can climb back to around 5.75 per cent. In other words, despite the repo rate cut, the market expects the central bank to take further measures in the credit policy to maintain its bias towards soft interest rates.
The market is also interpreting the RBI move as yet another measure to clamp down on the arbitrage opportunities that exist between the United States and Indian markets on account of interest rate differentials.
In July, the central bank took the first step to stop arbitraging by capping the interest rates on non-resident (external) deposits at 250 basis points above the London inter-bank offered rate (Libor) of corresponding maturity.
Even though the 10-year US treasury yield has gone up substantially, the interest rate differential at the shorter end is still very high. For instance, one-day money in the US costs 1 per cent, against 5 per cent in India.
Similarly, the one-year US treasury yield is around 1.35 per cent, against the 4.98 per cent yield of the 364-day treasury bill.
"The cut in the repo rate will bring down the short-term rates sharply and wipe out arbitrage opportunities," said a banker.
"With excess liquidity, the inflation rate ruling below 4 per cent and the bias towards soft interest rates, the conditions were favourable for a repo rate cut. However, the market was expecting it to happen in October. There will definitely be a rally in bond prices," said M R Madhavan, money and currency strategist, Bank of America.
Neeraj Gambhir, head of proprietary trading, ICICI Bank, said the repo rate cut had reinforced the soft interest rate bias. "It will provide an impetus to economic growth," he said.
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