Immediate reaction of the markets was to assume that since RBI had announced CRR cut, going forward RBI will cut down on conducting OMOs. This immediately impacted the long dated securities which was evident from the intra day movements of 10 year bench mark paper. Post the CRR cut announcements, benchmark yield corrected positively & breached 8.10% for some time before finally settling at 8.35% levels.

Generally, RBI buys long dated securities under OMOs. This was evident from the rally which happened in long dated securities from December onwards when RBI started conducting OMOs. During the same period, there was hardly any movement at the shorter end of the curve of 1-3 years. Following chart will depict this very clearly:

However, I believe that, given the present level of liquidity deficit, RBI will continue with OMO auctions, giving support to the bond market as the liquidity deficit is expected to increase in the month of March due to advance tax payment, currency leakage and increased economic activity in the last quarter.

Every spike in long dated securities should be treated as an investment opportunity. I had mentioned in my note dated January 17’2012 on AXIS CONSTANT MATURITY SCHEME that debt markets will give enough opportunities from now to March end & hence had recommended investment on weekly basis in the said scheme.

GOING FORWARD: FOR IMMEDIATE ACTION:

Immediate impact of CRR cut will be felt (and is already being felt) in short to medium dated securities in 1-3 year segment.1 year CD has already rallied from 9.98% to 9.80% levels & will rally at a much faster pace once CRR cut comes into effect from Friday onwards. This is exactly what I had mentioned in my note dated January 20’2012 wherein I had talked about the positive impact of CRR cut, rate cuts,etc on the shorter end of the curve. RBI action of CRR cut has aided this process sooner than later.

I would therefore recommend investments in the schemes mentioned in my January 20’2012 dated note at the earliest (read before Friday i.e. January 27’2012)

Clear indications have come from MoF, both from Finance Minister & from Chief Economic Advisor Mr Kaushik Basu by stating that Central Bank’s monetary tightening has only harmed growth without taming inflation.

Let us analyse the following data which is prior to RBI tightening the monetary stance (since March last year) & current state of affairs. This will also highlight the fact that RBI has failed to control inflation inspite of almost 11 rate hikes since last March & growth has been most affected; which is clear from July 2011 IIP numbers which have fallen to 3.3% from 6.6% achieved in June:

Hence, as can be seen from above, inspite of several rate hikes (to tame in inflation), your headline inflation numbers have been stubbornly hovering way above RBI comfort zone of 6% or below (though it has come down from 14% to currently at 9.78% for August 2011) .

Going forward, with maybe one or two more rate hikes of not more than 50 bps, RBI will at some time in near future adopt a neutral stand on interest rates & then start concentrating on growth once again over the next 6-9 months time. This will be signalled either by cutting CRR, announcing OMOs, etc. In short it will have to start infusing liquidity & kick-start spending and creating environment for growth in the economy.

In most probability, RBI will have one more rate hike during their review on Friday, which in turn will have some upward tick on the 10 year benchmark yield from the current levels. One may wish to start investing in G Secs on that date & as mentioned time & again, create a weekly SIP till October end. After creating this average, one can wait for the right cues from both MoF & RBI which will then translate into yields easing off.

In this strategy, one will have to be nimble footed in terms of their exit as on any positive news, benchmark yields tend to ease off suddenly. This happened between July 29 (benchmark yield was 8.45%) & the same eased off to 8.25% on August 18’2011 giving rise to handsome gains to the portfolio.

Having said that, no one expected inflation to remain at such high levels and also the current crisis in the vegetable prices (which will reflect in food inflation numbers going forward) RBI has also revised upwards their inflation targets of March from their earlier estimates of 5.50/6 %; clearly showing the lack of clarity on this issue and genuine concern for the same.

Based on the above, it is a foregone conclusion that RBI will raise rates in the January end policy review. Though 0.25 bps is already discounted, there is generally a concern amongst the market participants that it may be as high as 0.50 bps as well. This will have very strong negative sentiments in the already bearish debt markets & its negative impact on the equity markets as well.

All this is evident by the already higher cost of borrowing by some of the premier institutes like HDFC & SBI. HDFC is raising one year money at 9.55% & SBI has raised Rs.2000 Cr for 2 years at unusually high rates of 9.85% payable at quarterly compounding. This clearly shows the market trends on where the interest rates are headed. System is still hugely negative to the tune of Rs.85,000 Cr and is showing no signs of easing up inspite of the fact that RBI has already initiated OMOs of Rs.48,000 Cr and  some maturities and coupon payments of close to Rs.45,000 Cr in this month.

Almost Rs.1.10 Lac Cr of CDs are maturing in the month of January & close to Rs.2.20 Lac Cr are maturing in March. February numbers are not clear. Hence a total of Rs.3.50-Rs.4.00 Lac Cr of CDs will come into the market for further borrowing to replace the old ones. Combine this with rate hike expectations, the interest rate scenario becomes quite scary.

One more event after the January policy review which will have major bearing on the interest rate scenario is the Fiscal deficit numbers in the February Budget and the overall borrowing calendar for next year. Consensus is that due to higher GDP growth, though the gross level borrowing will be lower, on net absolute number basis the borrowing will be on the higher side.

Also, the disinvestment momentum of PSU stocks seems to be taking a breather with stock markets also turning bearish & hence the overall estimate of collecting Rs.40,000 Cr by March end might not be achieved.

The only positive silver lining to this whole interest rate/inflation/liquidity scenario is that Government has surplus with RBI to the tune of almost Rs.80,000 Cr which they have not spent so far. Either Govt spends this money aggressively in this quarter or carries forward this positive balance to the next Fiscal Year (thereby hopefully reducing the overall borrowing to that extent); in either event, markets will take some breather from this & might have positive impact on both liquidity & interest rate scenarios.

For quite sometime, I have not given any interest rate call or duration call (except for investing in G Secs on weekly SIP basis and exiting at any correction either due to fundamental or technical reasons & hence only a trading call). I continue to believe that this still is not the time to take long term call  on any debt asset classes. One should wait for the January policy review and announcement of rate hikes as expected and lock in long term funds into double indexation one year FMPs. I think one should yield close to 10% if invested post the policy review announcements. Short term/medium term & long term interest rates will hover on the higher side till RBI takes any action on easing of liquidity or Govt starts spending aggressively & for various reasons as mentioned above.

Besides the long term FMPs we continue to recommend investing in Templeton India Short Term Income Plan and BNP Paribas Bond Fund with a 1 Year Plus horizon. One should invest in these schemes post the RBI policy review.

Our weekly GILT SIP Strategy since July 2010 till date has given following returns:

Since July 2010 the benchmark yield has gone up from 7.72% to 8.21%, inspite of that this strategy so far has given positive returns as shown below:

Positives from the announcements were that RBI categorically mentioned that rates are now likely to be on hold for the immediate future. Also, they announced buy back of Rs.12000 Crs including 7.80% 2020; giving some more life to the already out of favour 10 year benchmark.

US government bail out package of nearly $600 Bln will further fuel the already on fire various asset classes like equity & real estate & commodities like gold, silver & oil. This will have further pressure on inflation numbers worldwide. RBI is rightly concerned on the inflation numbers (which have of late started cooling off with food inflation coming down slowly & steadily due to the impact of very good monsoon). However, ever growing interest of FII in the Indian equity & with huge inflow of foreign funds into the Indian equities, RBI will have some work cut out of for them on the liquidity front. Currently nearly negative systemic liquidity of close to Rs.70000 Crs is helping absorb these FII inflows without RBI getting unduly worried on the inflation front due to this growing liquidity in the equity markets.

Though RBI mentioned about going easy on further rate hikes, very next day they clarified that immediate future meant next 3 months. Hence, with possibility of advance tax outflows, profit booking by FII for their year end targets & subsequent reverse outflow of liquidity out of the country, a further rate hike possibility in January 2011 based on how inflation numbers cool off will determine the trajectory of the benchmark yields breaching 8% once more before cooling off in the first quarter of January 2011.

RBI has announced buy back of Rs.12000 Crs & there is further possibility of RBI repeating the same based on liquidity concerns in the market. There is G Sec redemptions happening in January & February 2011, add to this the year end spending by govt & year end buying by the Financial Institutions like LIC, etc will create a very healthy demand for G Secs in the last quarter of the FY 2010.Also, Inflation number coming down to between 5.50% to 6% by March end (estimates of RBI) will also help yields of G Secs to cool off below 8% mark.

Hence, after hovering between 8-8.10% levels over the next few months more, G Secs yields will cool off to between 7.50 to 7.75% in the next quarter beginning January 2011.

I continue to recommend investing in Long Term G Secs on every Friday for the next couple of months. This strategy so far has given excellent results in spite of the fact that 10 year bench mark yields have gone up from 7.70% to 8.15% since July policy to now. For an average holding period of 51 days since July & investing Rs. 1 Cr every week since July 27 to November 4, some of the G Sec schemes have given following positive results: