Fuel price hike delay only hindrance to a rally

The government is holding back a rally in bonds due to its reluctance to bite the bullet and hike fuel prices.

Crude oil prices (Brent Crude) are higher by 23% calendar year to date, and the government is yet to pass on the rise to the consumer. As a result the government’s subsidy bill is increasing as it has to compensate oil marketing companies for their losses.

The subsidy bill is estimated to cross Rs175,000 crore if crude oil prices stay at current levels of $113 per barrel and is not passed on to the end user.

The government’s inaction also hampers the Reserve Bank of India’s (RBI) ability to arrive at a correct inflation forecast. The RBI is forced to take monetary steps as the government continues to subsidise fuel consumption. That also defeats the whole purpose of RBI trying to cool off demand in the economy in the face of rising inflation expectations.

The market has everything going for it for a healthy rally from current levels. Inflation and interest rate hikes are on their last legs of negative surprises.

The ten-year benchmark bond, the 7.80% 2021, is trading at levels of 8.26%, down 20 basis points (bps) from highs seen a couple of weeks back but higher by 40 bps fiscal year to date (April 2011 to present).

Bond yields rose on the back of worries of inflation, rate hikes and government borrowing.

Inflation as measured by the Wholesale Price Index printed at 9.06% for the month of May 2011 with manufacturing inflation coming in at 7.3%, higher by 1.1% month on month.

Given inflation printing at over 9% levels and given that inflation is yet to reflect the rise in crude oil prices, the RBI raised the benchmark policy rate — the repo rate — by 25 bps in its policy review on June 16.

The RBI has guided for another 25 bps hike in July signaling its focus on bringing down inflation expectations. Inflation will be impacted negatively if the government hikes fuel prices, but apart from that there are no great drivers for inflation in the current environment.

The RBI has acknowledged that there are threats to global growth in the form of US unemployment, China rate tightening and Eurozone debt issues. The RBI has also taken note of fall in the Index of Industrial Production, which came at 6.3% for April, a 1% contraction month on month.

Unless inflation drivers of global growth and domestic demand flare up, inflation expectations will trend down rather than up. The market, while factoring in another 25 bps rate hike in July, will expect monetary policy to turn neutral from tight in the coming months.

Government borrowing is expected to be higher than net budgeted levels of around Rs3,40,000 crore. The rising subsidy bill will impact borrowing negatively in the second half of this fiscal.

However, if the extra borrowing is not yield threatening the market will shrug it off. The healthy corporate advance tax numbers of
Rs30,000 crore (higher by 75% year on year) for the first quarter of fiscal 2011-12 is positive for market sentiment on government borrowing.

Higher tax collections coupled with fuel price hikes (expected soon) will improve government finances and this improvement can sustain a bond rally.

Liquidity tightened towards the end of last week on the back of advance tax outflows of over Rs30,000 crore.

Bids for repo at 7.5% were at Rs85,000 crore on the last two days of the reporting week, higher by Rs35,000 crore from the average of Rs50,000 crores seen in the first three days of last week. Liquidity is expected to come back into the system through maturity of cash management bills and bond maturities.

Cash management bills of Rs28,000 crore are outstanding and these will mature over the next one month. The maturity of 9.39% 2011 on the 2nd of July will bring in Rs37,000 crore into the system. Liquidity, while in a deficit mode, is not a cause for concern for the market.

There were no government bond auctions held last week.