The first half of 2010 will be a period of normalization in policy making while the second half should be well back to our ‘normal’ world of uncertainties. The Year 2009 saw major gyrations in market prices as policy makers, globally, undertook unprecedented steps to prevent an economic and financial collapse and the asset prices reacted to the expected impact of these policy changes on the real economy.

In the first quarter of the year 2009 – asset prices reflected the disappointment of policy responses with the equity markets crashing to new lows and bond prices rallying (yields falling). As the economic stimulus worked its way through and the central banks low interest rates and infusion of liquidity attained permanence, economic data points started improving boosting confidence and equity and commodity prices staged its comeback with vigor.  Bond yields spiked up bearing the burden of the stimulus. Dollar took over as the carry trade currency and reversed its appreciating trend. Gold continues to benefit from the reckless money printing by the central banks around the world.

It was all synchronous around the globe. Volatility was the ‘Thing’. The table surmises better.

Table I – Asset prices gyrate

Although, asset prices can remain volatile, their movements would be reflective of the ‘normalisation’ of policy making. We have already seen central bankers talk about the ‘Exit’ Policy. That ‘Exit’ is in reference to un-doing some of the extra-ordinary measures of rate cuts, liquidity infusions and market interventions carried out in 2008/09. Recent Bond and currency market movements are already reflecting the eventuality of increase in interest rates and tighter liquidity by central banks around the world. Some countries may also have to roll back their economic stimulus as a high fiscal deficit situation becomes a concern to economic stability.

Indian Context –  RBI to ‘Normalize’ – Short term rates to rise

As written in our previous Quantum views’, the RBI would look to normalize its monetary policy. Reverse Repo rate at 3.25% for a sustained period  - with GDP growth now at +7%; IIP in double digits; Inflation expectations high with headline all set to touch 9% and asset prices on a full blown recovery  - is not justified. Thus, we expect RBI to raise its benchmark rates by 75-100 bps in the first quarter in response to economic recovery and high inflation and 25-50 bps in the second quarter. This we believe is only normalizing as RBI is already behind the curve (see chart 1). The rates were slashed aggressively in 08/09 to support growth and once it has stabilized it is time to wear the conservative hat.
But we do believe that RBI will not tighten liquidity by too much. The use of CRR or MSS would be limited depending more on the capital inflows driven excess liquidity. We only expect a 50 bps hike in CRR till March 2010. RBI would ensure adequate provision of liquidity for lending at reasonable rates. Even bankers themselves might prefer rate hikes than CRR impounding.

The second half would depend on the strength of the global growth and inflation scenario in the face of stimulus and monetary policy exits. But if growth tends towards 8%, expect some more rate hikes.

Chart I – Historical data shows Repo rates are already lagging GDP growth trend – fuelling inflationary expectations.

(Source – Bloomberg, Quantum Estimates)

For its policy actions, RBI is more concerned about manufactured goods inflation and the capacity utilization. Manufactured price inflation has been on an upswing and is already above 5% on a fiscal year basis. And looking at the increase in IIP and PMI, we believe the industrial outlook surveys would point to higher capacity utilization.

We can also juxtapose the current environment to a bit like 2004. The economy was recovering from a slowdown, credit was picking up, investment cycle was reviving, food and commodity price inflation was rising, high capital inflows and hence liquidity was high and the RBI at that time did respond with interest rate and CRR hikes of 50 – 100 bps in end 2004 going into 2005. We believe we are going to see something very similar this year.

We are positioning for a GDP growth of 6.9% for Fy 10E and a 7.5% growth in FY 11E. 
WPI Inflation would peak in Feb 2010 at close to 9.0%. But with falling food prices and a positive base effect we are forecasting Calendar year 2010 average inflation at 5.5%. High global growth could lead to higher commodity prices, which might lead to a higher inflationary scenario. RBI would settle for a 5.5% inflation in CY 2010.

Short – Tenor Outlook
So we expect short term rates to rise by 100 – 150 bps in the first half of the year due to the impact of higher benchmark interest rates.  The OIS markets are already pricing in a 100 bps increase in benchmark rates. Given the outlook, investors would be better off remaining invested in liquid funds for the next 3-4 months to benefit from the re-investments and no MTM. Short term non-liquid funds could incur MTM losses on their CD/CP portfolio.  Also, redemptions from banks could result in dislocations in short term assets pricing. SEBI’s proposal to make MTM on CP/CD’s mandatory could also lead to volatility in NAVs of non-liquid schemes.
We do not expect immediate increase in FD rates of 1 year and above. But given the outlook, it would be prudent to not lock in to FD rates of longer maturity now. Wait for the RBI actions and banks responses. March would be a better month to allocate.
 
Longer Tenor
We believe that the yield curve will flatten in 2010 in a big manner. The difference between short term and long term rates will narrow as short term rates rise.
We do not see any major sustainable spike in longer tenor rates. We believe that 10 year g-secs at above 8% offers good value.
Banking on Government to increase FII limit on G-secs from the current $5bn to ensure smooth sailing of Fy 10 fiscal issuances.
No major changes expected in credit spread. If anything, select issuer spreads could narrow. Healthy economic recovery bodes well for corporate balance sheets.
More than half of the FII limit on corporate bonds still unutilized, which would be handy if and when mutual funds face redemptions in their income funds.

Fiscal Deficit – a credibility question mark
Although the centre keeps talking about a 5.5% fiscal deficit in Fy 11, we think it would be extremely difficult to manage it. We expect the government to increase the excise and service tax rate which was reduced last year. So tax growth of around 25% is possible given the underlying economic recovery. Also, the outflows on pay-commission and loan waivers won’t be around this year and disinvestments should roll out as the leg work is being done this year.

A 6% Fiscal Deficit would mean net borrowing of close to Rs 4 tn. This looks very challenging in a scenario of higher interest rates, credit off-take and no OMOs. Therefore, opening up the FII limit is crucial to ensure no major spike in yields. A credible road-map to FRBM is crucial for long term economic stability. We do believe the government is serious about reducing deficits.

INR appreciation mode – positive for bond FII investors
The strength of the rupee of course depends a lot on global growth and risk appetite. India should continue to receive portfolio flows of the current years order if risk appetite remains high. We expect a higher proportion of ECB flows in 2010 as Indian lending rates remain sticky. Recent FDI numbers are also encouraging and it should increasingly move forward.

So although, we would run current account deficits of around 2% ($25 bn), net capital flows of around 4% of GDP can be expected in 2010/11 thus giving an appreciating bias to the rupee. Of course, any minor changes in global appetite can also lead to capital outflows and depreciating rupee.

But we continue to believe, that our external sector is no longer vulnerable and any sharp depreciation should be a key trigger to go long on the rupee. India’s high nominal yield relative to some emerging peers and the prospect of currency appreciation bodes well for FIIs investing in bonds. India has also underperformed most asian peers in 2009 as the others have posted strong gains, so allocations this year could tilt towards India.