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:

POST BUDGET: We had recommended the following:

• To stay away from long end of the curve for following reasons
• Fiscal stimulus roll back
• Petrol price hike
• CRR hiked by 75 bps since February 13’2010
• Reverse REPO figures started coming down from Rs.1 lac cr to Rs.30,000 crs & likely to go negative by June
• Heavy front loaded borrowing calendar with no OMO calendar
• 1 year CD up from 5.75% in January 2010 to 7% in March
• 5 year AAA Bonds up from 8.40% to 8.75% in the same period
• 10 year benchmark marginally higher at 7.90% from 7.80% in January 2010

March 19’2010:

RBI increases Reverse REPO by 0.25% to 3.50% & REPO Rate by 0.25% to 5.00%

April 20’2010:

RBI further increases Reverse REPO by 0.25% to 3.75% & REPO Rate by 0.25% to 5.25%

April 24’2010:

RBI increases CRR by 0.25% to 6%; thereby sucking out liquidity

BLOG NOTE DATED: April 26’2010:

• No interest rate calls
• RBI Hawkish with upward interest rate bias and lower liquidity
• Investment in defensive portfolios with lower duration/higher carry

BLOG NOTE DATED: May 22’2010:

• 3 G auction collection of more than Rs.68,000 crs
• Long end going down & short end going up due to borrowing by Telecom companies to bridge their immediate payment requirements
• Systemic liquidity expected to go negative due to forthcoming advance tax outflows and redemption pressure from Banks
• Given a call to exit out of aggressive short term funds for above reasons as well as new MTM guidelines likely to kick in from July 01’2010

BLOG NOTE DATED: June 14’2010:

• BWA Auction to suck out additional Rs.39,000 crs by June 21
• WPI for May higher than expected at 10.16%; increasing fear of further rate hikes

July 02’2010:

RBI increases Reverse REPO by further 0.25% to 4% & REPO Rate by 0.25% to 5.50%. CRR untouched at 6%

July 27’2010:

RBI increases Reverse REPO Rate by 0.50% to 4.50% & REPO Rate by 0.25% to 5.75%

BLOG NOTE DATED: July 27 & August 03’2010:

• 10 year benchmark inching up from 7.70% to 7.80-85% & likely to breach 8% mark
• Expectation of further rate hikes in September & October policy reviews
• Recommended staggered weekly investment in long term G Sec schemes over next 3-4 months to take advantage of rising yield
• Expectations of  benchmark cooling off below 7.50% by March 2010

September 16’2010:

RBI increases Reverse REPO by 0.50% to 5.00% & REPO Rate by 0.25% to 6.00%; CRR untouched at 6.00%

Hence since March 2010 RBI has increased:

REVERSE REPO Rate by 175 bps

REPO Rate by 125 bps &

CRR by 25 bps

GOING FORWARD:

• RBI seems to have done what it wished to in terms of tightness in liquidity & increase in benchmark rates to curtail inflation
• More than expected 25 bps extra hike in Reverse Repo rate has ensured that the corridor between REPO & Reverse Repo is further narrowed; thereby reducing volatility at the shorter end of the curve
• RBI statement seems to indicate that they are going from very hawkish to neutral rate stance & maybe dovish stance
• Global cues are extremely negative & hence RBI might not be able to sustain  increasing  interest regime for a much longer
• US benchmark rates are at historical lows
• Further increase in interest rates just might attract foreign funds to take advantage of interest arbitrage opportunities
• This might act counter to RBI’s intention of keeping liquidity tight to curb inflation
• Liquidity will remain tight for a few more months till such time Govt starts to spend aggressively by October
• Market is expecting tightness to continue till September end; come back to neutral by beginning October & some surplus by November onwards
• This will ensure short term & long term rates to hover at current levels for some more time before cooling off on the back of lower inflation numbers & liquidity coming back
• Markets will give ample opportunities to investors to invest both in Short Term Funds (more weightage to this asset class as interest rates will start easing off at shorter end with liquidity coming back)  as well as Long Term Funds (staggered weekly over next 2-3 months)  from hereon without too much fear of very aggressive hikes in the near future
• If at all, RBI might go easy on any further rate hikes based on inflation numbers, liquidity numbers

However, this event (read Budget) has had an effect of creating more ripples in an otherwise calm market. There have been many announcements (like petrol price hike, excise duty hike, etc) which will impact inflation & debt markets in the short run but will go a long way in improving fiscal deficit numbers in the long run.

Let us analyse the debt market situation of last couple of years v/s what is likely to be going forward:

As against the above, going forward debt markets will have to weather following hurdles:

Taking into account the above factors one would be best advised to stay away from taking any long term investment calls in the debt markets at current levels. Interest rates have started hardening both at the shorter end (more so in this segment of the yield curve) as well as on the longer end. 1 year CDs which were quoting at 5.75% in January 2010 have already hardened to 7% plus in a very short span. 5 year AAA Corporate Bonds’ yield has hardened to 8.75% from a low of 8.40% pre Budget & 10 year benchmark has marginally gone up from 7.80% to 7.90-7.95%.

With imminent hike in inflation numbers, there will be an imminent rate hike in the near future. Add to this the liquidity woes & huge weekly borrowing calendar; benchmark rates in such a scenario can breach 8% mark soon & may hover between 8.25% to 8.50% levels in the near future. Hence, instead of trying to outguess RBI moves or debt markets, one can safely invest in say 3 month FMPs at or around 6% levels, go beyond March 2010 & let inflation peak off somewhere at 10% levels between April & June 2010 before taking a long term call on debt markets at those levels.

Both for technical (good opportunity to invest at higher yields as well as lower borrowing programme in second half) & fundamental reasons (base effect on inflation bringing the inflation numbers to around 5% in August/September 2010) it will make an immense sense to invest in long term Income/GILT schemes at that point in time.