Aug. 5 (Bloomberg) -- The difference between India’s three- month and three-year interest-rate swaps will narrow from a near-record high as the central bank raises borrowing costs to curb inflation, DBS Group Holdings Ltd. said.

The Reserve Bank of India, which stopped cutting rates last month after six reductions since mid-October, will start increasing its repurchase rate as early as December, Jens Lauschke, a fixed-income strategist at DBS, Southeast Asia’s largest bank, said in an interview yesterday. Central bank Governor Duvvuri Subbarao boosted India’s growth forecast on July 28 and said inflation will “creep up.”

“The response to inflation is going to be stronger than what it looks as of now,” Singapore-based Lauschke said. “Inflation is the next big issue and will emerge sooner as the monetary-policy statement reflects.”

Lauschke recommends investors agree to pay fixed three- month rates in exchange for floating payments to benefit from such a change in policy as the short end of the swaps curve climbs faster relative to the three- and five-year segments. Investors should also agree to receive three- and five-year fixed rates in exchange for floating-rate payments, he said.

The spread between the three-month and three-year swaps widened to a record 2.21 percentage points on June 17 and was at 2.17 points today, according to data compiled by Bloomberg. The gap may narrow to less than 2 percentage points within a month, according to Lauschke.

Yields, Rates

In an interest-rate swap, two parties agree to exchange payments over a period of time. Typically, one agrees to pay a fixed rate, while the other pays a rate that fluctuates with a benchmark index or formula defined in the contract.

The Reserve Bank of India will raise the repurchase rate and the reverse-repurchase rate by 0.75 percentage point each to 5.5 percent and 4 percent by March, Lauschke said.

“We are discounting rising rates in intermediate maturity swaps like the three- and five-year,” he said. “The front end of the curve will move more than the far end.”

The central bank last week raised India’s growth forecast for the year ending March 31 to 6 percent “with an upward bias” compared with the 6 percent it estimated in April. It said wholesale prices will accelerate to around 5 percent by the end of March, compared with an estimate of 4 percent made in April.

The key inflation index dropped for a seventh straight week, falling at an annual pace of 1.54 percent in the seven days to July 18.

India’s benchmark 10-year yield will rise to 8 percent by March, from 7.09 percent today, Lauschke said. The rate has climbed 1.83 percentage points this year.

The central bank’s attempt to boost cash in the banking system by buying bonds won’t prevent yields from rising, DBS said.

Indian government bonds have lost 4.2 percent this year, the worst performance among 10 local-currency debt markets, according to an index compiled by HSBC Holdings Plc.

To contact the reporter on this story: Anoop Agrawal in Mumbai at aagrawal8@bloomberg.net.

Last Updated: August 5, 2009 08:23 EDT