Comment

Expectations from January policy review will be of a 50 bps cut each in the repo and reverse repo rates

The Reserve Bank of India (RBI) on Saturday cut benchmark policy rates by 100 bps from 7.5% to 6.5% and the reverse repo rate by 100 bps from 6% to 5%.

The reverse repo rate cut effectively means the RBI is penalising banks who have excess liquidity and want to park the money with the RBI at the reverse repo rate instead of lending it out.

The repo cut suggests that the RBI will provide liquidity to the banks at a lower rate in order for the banks to bring down their lending rates.

The rate cuts also signal that the central bank wants interest rates to come down in the system in order to give a fillip to economic growth.

The market had discounted the cuts with the yield on ten-year benchmark government bond trading at three-year lows of 6.75%.

The market will now start factoring in further rate cuts by the RBI. Expectations into the January 2009 policy review will now be a 50 bps cut in both repo and reverse repo rates.

The rate-cut expectations will stem from the fact that economic slowdown will be sharper than expected and inflation will be lower than expected. The GDP growth forecast for 2008-09 has been steadily revised downwards by the RBI from 8.5% to 7.5%. Economists are expecting a GDP growth of less than 7% for 2008-09 and less than 6% for 2009-10.

The first signs of faster-than-expected GDP slowdown will be seen in the Index of Industrial Production (IIP) growth numbers. The IIP is expected to show negative growth for November and is expected to continue to show negative growth for the following months.

Inflation as measured by the Wholesale Price Index (WPI) is expected to go below 4% in March 2009 on the back of the fuel price cuts. The government is expected to reduce fuel prices further given the sharp fall in oil prices to around $40/bbl, which is a four-year low. Economists are expecting inflation to print below 2.5% in 2009 on the back of sharp falls in commodity prices.

The RBI will also keenly watch data stemming from global economies for its policy measures. The US lost more than half a million jobs in November, signifying recessionary trends. Economic data from the Eurozone and China are also looking bleak and these economies are reducing policy rates aggressively to prevent growth from falling off the cliff.

The government has announced an additional Rs 45,000 crore of borrowing for fiscal 2008-09. The borrowing is larger than expected and the market is expecting an additional borrowing of around Rs 25,000 crore to Rs 35,000 crore.

The government borrowing will be accompanied by buyback of Market Stabilisation Scheme bonds, making the borrowing liquidity neutral.

Liquidity was positive last week, with bids for reverse repo at 6% touching Rs 56,000 crore. Liquidity was comfortable as banks were well-covered on their products in the reporting week. Overnight rates trended at reverse repo levels of 6%. Liquidity is expected to be positive this week as the system is going into a fresh reporting fortnight with a good surplus.

Government bonds
Government bonds saw yields move down week-on-week. The benchmark ten-year bond yield closed the week lower by 32 bps, with the 8.24% 2018 bond closing the week at 6.76% levels. The five-year benchmark bond, the 7.56% 2014 bond, closed down 34 bps week-on-week at 6.68% levels. The long bond, the 7.95% 2032 bond, moved down by 40 bps week-on-week to close at 7.29% levels.

The government is scheduled to hold a government bond auction for Rs 10,000 crore this week. The market will take direction from the auction cut-off expectations.

Treasury bills
Treasury bill (T-bill) yields were lower in the auction last week with the cut-off on the 91-day T-bill auction held on December 3 coming in at 6.60% against a cut-off of 7.14% seen the previous week. The 364-day T-bill auction saw the cut-off coming in at 6.30% against a cut-off of 7.09% seen in the previous auction. The RBI, this week, is auctioning Rs 5,000 crore of 91-day T-bills and Rs 500 crore of 182-day T-bills under regular auction.

Corporate bonds
Corporate bonds saw yields fall as market bought into higher spreads. Ten-year benchmark AAA spreads fell 67 bps to close at 318 bps levels while five-year benchmark AAA spreads moved down 50 bps to 376 bps levels. Primary issues are expected to hit the market as corporates look to borrow at lower yields on the back of rate cuts.

Overnight index swaps (OIS)
OIS saw the curve steepen on rate-cut expectations. The one-year OIS yield moved down 45 bps to close at 4.95% levels. The five-year OIS yield closed down 30 bps at 5.40% levels. The one-over-five spread steepened by 15 bps to close at 45 bps levels. The OIS curve is expected to factor in further rate cuts and will look to trend down.

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