India swap rates curve suggests RBI may ease; but not quite yet

* OIS curve shows Indian rate cuts this month unlikely

* RBI may opt to ease cash conditions via debt buybacks

* OIS inversion may touch 100 bps if RBI stays on hold

By Swati Bhat

MUMBAI, Oct 12 (Reuters) - As pressure builds on India's central bank to ease monetary policy after a slew of fiscal and economic reforms, the debt market is cautiously positioning for policy rates to be cut, but remains unconvinced that it will happen this month.

Asia's third largest economy is mired in its worst phase of stagnation since the global economic crisis three years ago, and

industrialists and politicians have beseeched the Reserve Bank of India to cut rates.

The RBI holds its next quarterly policy review on Oct. 30, and many economists believe it will keep its policy repo rate unchanged at 8.0 percent, due to concerns over an inflation rate that is the highest among major Asian economies.

Since last month, the government's reforms, including a hike in diesel prices and allowing more foreign direct investment in the aviation and retail sectors, have helped lift some of the gloom in Indian markets.

Equities rallied and the Indian rupee firmed sharply. And the overnight indexed swap (OIS) curve, the curve widely used to bet on interest rate moves, has also turned.

It used to be deeply inverted, with short term rates higher than longer term rates, reflecting an economy where the central bank is focused on fighting inflation despite slowing growth.

That steep inversion has been gradually unwound, with short term rates falling.

Still the curve remains inverted, with short-term rates far higher than longer tenors, suggesting the market is reluctant to fully price in an October rate cut.

Few economists argue against the need for interest rate cuts in an economy growing at its slowest in nearly three years. The question has always been the timing, given the inflation rate.

Data due on Monday is expected to show an acceleration in wholesale price inflation to 7.70 percent in September, the highest this year.

Even if the data surprises on the downside, market players would want to see a sustained trend of slower price rises.

"I do not expect a rate cut till January as inflation is the only factor that monetary policy should be concerned about, and inflation will go up before it comes down," said A. Prasanna, chief economist with ICICI Securities Primary Dealership.

<^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Asia inflation graphic: GRAPHIC-Inflation,rates,IIP: India OIS curve: India's Sept inflation likely hit 2012 high Worst may be over for India's economy ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

Other analysts agree, warning against taking the shifts in the OIS curve as a sign that the RBI will cut rates this month.

India's OIS curve has been inverted since May 2011 as growth prospects slowed sharply but short-end interest rates stayed elevated due to a domestic cash squeeze and the RBI's aggressive monetary stance.

Investors have bet on higher interest rates in the near-term, and lower interest rates in the longer-term, which is unusual as swap curves are normally upward sloping, just as other interest rate curves are, pricing in a premium for longer tenors.

The spread between one- and 5-year benchmark OIS swaps have been negative since last year. After peaking at around 107 basis points i n September 2011, this negative spread has narrowed to around 60 bps, suggesting the short end of the curve is bracing for a rate cut, though not necessarily an imminent one.

"The front end has not fully priced in a cut. If it had priced it in, the spread would have moved to positive territory," said Suresh Kumar Ramanathan, a forex and fixed income strategist at CIMB in Kuala Lumpur.

Should there be any suggestion that monetary easing will be delayed, the OIS curve is at risk of inverting further.

The 1-month OIS rate trading at 7.92 percent is marginally below the RBI's 8.00 percent repo rate. but had it priced in even a 25 bps cut, the OIS rate should have been closer to 7.75 percent.

"If RBI stays pat, then the curve inversion might head towards 100 basis points from current 60 bps," Ramanathan said.

(Editing by Vidya Ranganathan and Simon Cameron-Moore)