Comment

The Reserve Bank of India (RBI) is widely expected to hike benchmark rates in the first quarter review of the annual monetary policy for 2008-09 coming up on July 29.

Expectations of the rate hikes vary from 25 basis points (bps) in the cash reserve ratio (CRR) and 25 bps in repo to only CRR and no repo, to no repo and only CRR.

The current market sentiments reflect the fact that if the RBI goes for any of the above combinations, the market will take it in its stride and look ahead. However, if the rate hikes are more than expected or if the RBI tinkers with other benchmarks such as reverse repo or bank rate (both have been left unchanged for a while), then market sentiment can take a turn for the worse.

Going into the policy, the RBI’s focus is on containing elevated inflation expectations. Inflation as measured by the Wholesale Price Index came in at 11.89% for the week ended July 12, as against market expectation of 12.03%. The double-digit level of inflation has caught the RBI as well as the government off-guard and inflation fire-fighting has become the primary policy focus. Consensus estimates suggest that inflation is expected to remain in double-digit levels till the end of calendar 2008, while peak inflation levels vary from 14% to 17%.

The primary cause of inflation pessimism is crude oil, which is trading at $123/bbl, up by over 25% this calendar. The positives for the market are that crude oil prices have come off by 16% from highs of $147/bbl to current levels of $123/bbl. Inflation sentiments have eased to some extent as the last two inflation numbers were steady at around 11.90% levels. Growth expectations have come off with GDP estimates being revised downwards (from 8.5% levels to sub-8% levels). Global growth expectations have come off with major economies expressing pessimism on the growth front.

The current levels of the market — with the 10-year benchmark government bond at a multi-year high of 9.15% — is factoring in the worst in terms of inflation. The market has seen highs of 9.50% on the 10-year bond when oil prices touched $147/bbl and RBI raised CRR and repo by 50 bps each in pre-policy measure to quell inflation expectations.

The market will look ahead after the policy, on the effects of policy action on inflation and growth. The high levels of interest rates are expected to curb demand and bring down inflation expectations, while growth is expected to be affected. This is a positive interest rate scenario, which the market may embrace. The risk to the scenario pictured above is oil prices and RBI’s tougher-than-expected stance in the policy review.

Liquidity as measured by bids for reverse repo repo in the Liquidity Adjustment Facility (LAF) of the RBI was tight last week, with bids for repo at 8.50% in the range of Rs 40,000-50,000 crore. Overnight collateralised rates traded around repo levels of 8.5%, while call money rates hovered around the 9.5% mark. Liquidity is expected to remain tight given auction outflows of Rs 6,000 crore and on expectations of more CRR hikes in the policy review. Overnight rates are likely to remain in the 8.50% to 9.50% range.

Government bonds
Government bonds saw yields move up week-on-week, largely on the back of late Friday selling by the market. The benchmark ten-year bond got sold-off on account of speculation on the outcome of a meeting between the RBI governor and the finance minister. The bond yield closed the week higher by 7 bps with the 8.24% 2018 bond closing the week at 9.16% levels. Five-year benchmark bond yields were flat with the yield on the 7.27% 2013 bond closing at 9.30% levels. Yields on the long bond, the 8.33% 2036 bond, closed higher by 5 bps at 9.68% levels.

The uniform price auction for Rs 6,000 crore of 8.24% 2018 bond saw the cut-off coming in above market expectations in yield terms. The cut-off came in at 9.08% against market expectations of 9.05%. The bond sold off from lows of 8.97% pre auction to close the week at 9.16% levels. Bond yields will take cues from RBI policy actions this week.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were lower last week on the back of improved interest rate sentiments. The cut-off on the 91-day T-bill auction held on July 23 came in at 9.06% against a cut-off of 9.11% seen in the previous auction. The 182-day T-bill auction saw the cut-off coming in at 9.32% against a cut-off of 9.34% seen in the previous auction.

The RBI, this week, is auctioning Rs 3,000 crore of 91-day T-bills, all under regular auction, and Rs 2,000 crore of 364-day T-bills of which Rs 1,000 crore is under regular auction and Rs 1,000 crore is under the Market Stabilisation Scheme.

Corporate bonds saw yields trend down marginally in the five-year papers, while the short end continued to be pressured on supply. Five-year bonds came off by a couple of basis points at 10.68% to 10.75% levels, while one-year papers were dealt in the 10.75% to 11% range. Credit spreads were flat at around 123 bps levels. Corporate bonds yields will underperform government bonds if the market sentiments turn positive after the policy.

Overnight index swaps (OIS) saw the curve come off on the back of short covering ahead of the policy and on the back of falling oil prices. One-year OIS yields moved down by 4 bps to close last week at 9.48% levels, while five-year OIS yields closed lower by 11 bps at 9.41% levels. The five-over-one OIS spreads inverted by 7 bps to close at negative 7 bps. The OIS curve is likely to outperform government bonds if sentiments turn positive after the policy.

Disclaimer: The author is senior fund manager - fixed income, IDFC Mutual Fund. Views are personal.