Impact of rate hikes to be felt from April as liquidity dries up

Sticking to the mandate given by the government to raise monetary policy rates to fight inflation, the Reserve Bank of India (RBI) on Thursday raised repo and reverse repo rates by 25 basis points (bps) each and signalled further rate hikes going forward.

The central bank has cited rising inflation expectations in the form of rising demand pressures in the economy and rising oil prices for further policy rate hikes.

The inflation forecast for March 2011 stands revised from 7% to 8%, underlying the inflation pressures in the economy.

The rate hikes are in line with expectations and the market will start expecting further rate hikes in the next few months.

Bond yields, with benchmark bond yields at around 8.08%, have largely factored in further rate hikes, but bond yields are still to factor in potentially higher government bond supply next fiscal.

The bond supply will increase as the government foots a rising subsidy bill due to oil prices moving up by over 25% to date this calendar.

Middle East political issues are still hot and there will be further disruptions to oil supply.

The RBI has a made an observation that if Japan replaces nuclear with thermal power, oil prices can remain pressured.

Oil marketing companies are seeing an under recovery of Rs15.79 per litre by selling diesel at subsidised prices. The government does not have the political will to raise fuel prices in the face of state elections and the higher subsidy bill will result in higher government borrowing for fiscal 2011-12 against the budgeted net borrowing amount of Rs343,000 crore.

The liquidity situation is improving on the back of government spending, but given the RBI’s tight monetary stance, liquidity will be kept in deficit beginning fiscal 2011-12. The government will commence its borrowing programme in April in the face of deficit liquidity conditions, expected rate hikes and a worsening of subsidy bill. The bond markets will have to start factoring these into bond yields as they absorb the heavy supply.
What can prevent bond yields from rising too fast:

 Demand from banks for statutory liquidity ratio if they have raised heavy deposits at the end of March;

 Demand from FIIs who have unutilised limits in government bonds;

 Lack of alternative sources of supply for investors as states and corporates are light issuers in April.

Traders who go short bonds and hoping to cover in the auctions at higher yields will also be buyers in the auctions. However, the current level of bond yields at around 8.08% is good for going short rather than going long in the hope that demand may materialise.
arjun@arjunparthasarathy.com