Long duration stance on bonds will work on new FII limits, OMOs
Sun, 13 Dec 2015 08:42:59 -0700
We expect at least four more OMOs this financial year to inject permanent liquidity into the system
Yields moved up in the government securities markets and corporate bond markets in November due to expectations of a hike in US Federal fund rate after the US non-farm payroll stood at 2,71,000 for October. India’s CPI inflation for October was at 5 per cent due to higher prices of pulses and vegetables.

The recommendation of 23.2 per cent hike by the Seventh Pay Commission makes the achievement of the fiscal deficit target of 3.5 per cent for the next financial year look difficult.

The rupee was volatile, falling to 66.50 level from 65.20 against the US dollar during November. This was due to FII outflows from equity and debt markets in November. The 10-year yields moved up by 12 basis points and were trading at 7.76 per cent level from 7.62 per cent level at the beginning of the month.

Corporate bond yields spread compressed from 40 basis points to 35 basis points in the AAA PSU names. The rates on certificates of deposit remained stable with the three-month rates trading at 7.20-7.25 per cent levels.

In its December 1 money policy, RBI left key interest rates unchanged and also maintained its accommodative stance. Although it came with a bit of caution. It has cautioned on the potential inflationary impact of the Seventh Pay Commission as also on the need to be vigilant towards the price rise in some food products.

RBI has still maintained its inflation target of around the 5 per cent in March 2017. Given the factors laid above and the impact of an increase in service tax in the next budget, it would be a great challenge to meet the 5 per cent target.

We thus hold our view that the next rate cut (25 bps) would be possible only post the budget. With the RBI highlighting the impact of pay commission on the fiscal numbers, it would want to wait and see the markets response to the government’s ability to meet the 3.5 per cent fiscal deficit target.

If the market senses that the budget numbers are credible and the government has resources to meet the 3.5 per cent target, it would improve investor confidence and RBI will be able to utilise the limited space available to cut rates to 6.5 per cent. Any reduction in interest rates post that would depend on RBI achieving the 5 per cent inflation target.

RBI has cut rates by 125 bps since January 2015, but the total lending rate cuts passed on by banks have been less than 60 bps. For the economy to benefit from the low inflation and monetary accommodation; lending rates have to fall more, and quickly.

Even in the bond markets, post the fall seen in 2014 in anticipation of rate cuts; yields haven’t fallen much, as supply outstrips demand.

In an accommodative cycle, the liquidity situation has to remain plentiful for the banks cost of funds to fall, which then they can pass on to the borrowers. Data that we maintain show us that core liquidity (liquidity directly managed by RBI) which was surplus to the tune of Rs 80,000 crore in August has turned into a deficit of Rs 25,000 crore in November.

RBI needs to ensure that core liquidity swings back into surplus so as to ensure that banks can pass on the benefit of lower cost of funds by cutting their lending rates. As foreign inflows have dried up RBI will have to resort to buying government bonds to infuse durable (long-term) liquidity.

RBI has done an open market sale of Rs 10,000 crore and variable repo auction of Rs 25,000 crore to increase liquidity in the local markets. We expect at least another four OMO (Open Market Operation) in this financial year to inject permanent liquidity into the system.

We thus continue to like government bonds at these levels and continue to maintain our long duration stance with the expectation of term spread compression in the months to come as supply falls; foreign investors limits being released in January 2016 and the prospects of RBI buying through open market operations.

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