Debt Outlook
28th July, 2010
Arvind Chari- Fund Manager (Debt)
The narrowing of the corridor does not come as a surprise, and it does make a lot of sense in the current environment. In fact, there is a possibility that by the next review the corridor may further narrow down to 100 bps.
Since the system is likely to swivel between deficit (where overnight rate = repo rate) and excess liquidity (where overnight rate = reverse repo rate), a narrow corridor would make the money markets less volatile. This would also help banks to better price their base rates.
The markets would assume a mid-point as the average overnight rate for a period and price the money market term structure (upto 1 year).
With the inflation target raised to 6%, the RBI is clearly worried. Yes, the RBI is still ‘behind the curve’ on inflation management, more so since they were hoping for food inflation to fall – which has clearly not happened. And to add to that, capacity tightness is leading to a generalized inflation. Thus liquidity can be expected to remain tight, at least till inflation falls below 8%.
Banks will have to increase deposit rates to meet the robust credit growth under way. However, lending rates might not increase by much, and short term rates might maintain current levels.
1 Year OIS (Overnight Indexed Swap) will most probably be paid, and 2-3 year credit yields might increase as yields for 1 year might maintain current levels.
Long bonds will most probably take cues from credit growth. If credit growth remains high amidst tight liquidity, 10 year could be placed at around 8% from the current – 7.65%
The Mid-quarter review is a good step as the market won’t keep second guessing on the timing and date of policy action
The key issue however is liquidity. The system is grappling with tight liquidity and RBI cannot add any meaningful liquidity till inflation is under control. Reserve money has seen quite limited growth.
A credit growth with a six month lag to Industrial production can be seen. Thus a sharp rise in Credit can be expected. With short term rates low, Deposit growth had lagged credit growth. So banks will sell their excess holdings of treasuries to fund credit. At the same time, they will raise deposit rates, leading to a general rise in interest rates. So there could be some sell-off in the longer end in the interim.
There is a possibility that is inflation drops below 8%, liquidity might be added:
1) By either buying dollars – intervening – and not sterilizing it.
2) With the rupee depreciating on the back of high trade deficit, there is a clear case for increase in FII bond limits.
3) By buying government bonds – OMO.
It is very probable that a combination of the above might be actioned. So considering a slightly longer term view – we should be long bonds. Any sell off in the medium and longer end – should be bought into.
Factors for positive view
A) Inflation seems to have peaked – though it should most probably fall in the next month and ease to 7% by December.
B) Fiscal situation looks better. Tax growth is improving. Telecom auction and dis-investments help.
C) Will add liquidity once inflation eases. Can also cut CRR.
D) Curve to continue to flatten.
INR View still looks bearish while market sentiment appears negative as economists are juxtaposing the current trend and forecasting CAD of almost 3.5% of GDP. But there could be a possibility that the CAD widening was one-off due to higher payments by KPOs. If exports recover faster, CAD will remain well below 3% of GDP – supporting the rupee.
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