Interest rates will rise first, then fall by year-end

The 10-year yield will surge to 8% before sliding to 6.75% levels

MUMBAI: Calendar year 2006 was bearish for both interest rates and credit spreads. Interest rates were higher by 60 basis points (bps; 100 basis points is a percentage point or, in simpler terms, a per cent)) year on year with the benchmark ten-year Government of India security yield rising from 7% levels to 7.60% levels over 2006.

Credit spreads also saw upward movement in 2006 with the benchmark five-year AAA credit spread moving up by 30bps year on year from 80bps at the beginning of the year to current levels of 110bps. The factors which affected interest rates and credit spreads were the rate hikes by the Reserve Bank of India (RBI).

The RBI raised benchmark reverse repo rate three times in 2006 in January, June and July, while it raised the repo rates four times. Cash reserve ratio (CRR) was also hiked by 50bps from 5% to 5.5% during 2006. Reverse repo rate was raised by 75bps in 2006 from 5.25% to 6% while repo rate was raised from 6.25% to 7.25%.

The rate hikes were in order to control rising inflationary trends (5.3% as of end December 2006) in the economy, on the back of high growth in money supply (around 19% year on year) and non food credit (around 30% year on year).

The monetary measures by the RBI also increased the borrowing cost for corporates as banks were forced to increase lending rates on the back of high demand for credit against tighter liquidity and interest rate scenario.

What's in store this year?

Interest rates are in for a rough ride in 2007, but the end-of-2007 outlook is positive. Yield on he ten-year bond would move up from current levels of 7.60% to 8% levels before falling all the way down to 6.75% levels by the end 2007. Credit spreads will tend to move up.

The benchmark five-year AAA credit spread could ascend from current levels of 110bps to 180bps by end 2007.