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

• Credit policy is out the way
• Sentiments have gone negative & frequent utterances by RBI officials on giving priority to tackling inflation first and accordingly ensuring that liquidity does not come back into the system in a hurry has also not helped matters
• RBIs clear intention is to tackle inflation first & hence some more rate hikes in the near future
• As mentioned in my previous note on the eve of the policy all the other fundamental and macro reasons still remain the same
• Our system is currently short of liquidity by Rs 40,000 – 60,000 crore.  I believe, with this move of increasing the rates, the tightness in the liquidity will continue to remain for some more time.  Till we see aggressive spending or reduced borrowing by the government, the liquidity will not return in the system, thus keeping the short term rates elevated
• Govt. borrowing programme has been front loaded with 40% already completed reducing pressure on the latter part of the year
• Inspite of the fact, the 10 yr benchmark has inched-up to 7.85-7.86 % levels, I would treat these as investment opportunities to further increase exposure in the longer end of the curve
• I don’t know whether 10 yr benchmark will peak off at 7.80 or 7.85 or 8 percent level hence I would advise staggered investment in gilt schemes at various levels starting from now
• I would recommend not to invest in bond funds for two reasons :

1. There would be exit load issues if one invests in bond fund
2. Post the RBI policy review there is a possibility of spread widening between GSec and Bonds going forward

Also, I would recommend that your investment in long term portfolio also should be staggered on weekly basis starting now instead of parking your funds in say 3/6 month FMPs and losing out on opportunities coming your way. Please park that portion of funds in respective liquid plus schemes of those MFs in whose GILT Funds you would like to take exposure to & give weekly switch requests to switch into their G Sec Schemes starting now & staggered till say 3 to 4 months hence. i.e. say if you wish to invest Rs12 Cr in GILT, invest Rs.75 lacs to Rs.1 Cr every week from now to 3 to 4 months hence through Systematic Transfer Plans (STPs). This way you will average your investment without trying to time the market at the same time participate at every high levels of interest rates from say 7.80% to say 8% levels.

Also, 3 to 4 month horizon will take care of any intermittent rate hikes as well as October Credit Policy review.

As suggested in that note, 10 year benchmark in anticipation of further rate hike expectations have inched up from 7.65% to currently closer to 7.70% levels.

What is the way going forward from hereon:

Negatives in the market:

1. Inflation to further rise to closer to 12.25 to 12.50% & peaking off at these levels
2. Maybe erratic monsoon as seen in some of parts of the country & its repercussions
3. Further rate hikes in the future (taking the overall rate hikes for the year to between 125 to 150 bps as compared to last year)
4. Since 2003 when the interest rates were at their lowest & thereafter either remaining steady or only going upwards, Short Term Schemes as an asset class has outperformed long term GILT & Bond Funds on 1/2/3/5/7 year time horizons; dissuading clients to take unnecessary duration or interest rate calls

Positives in the market:

1. More than expected hefty revenue collections from 3 G/BWA Auctions, better than expected tax collections due to better corporate results. This still does not include any revenue collections from PSU disinvestments
2. Mechanism announced to free the petroleum pricing; thereby hugely reducing petroleum subsidy figures
3. Possibility of more foreign inflows expectations due to up gradation of GDP numbers by IMF
4. IIP numbers easing from a high of 16.5% to currently at around 11.5% & likely to go further down to single digit figure
5. After peaking off at maybe 12.50%; inflation to soften due to base effect kicking in & going to higher single digit by September & to approx 6-7% by March 2011
6. Demand/Supply of G Sec becoming more skewed in favour of demand in the year 2010-2011 than supply (reverse was the case for FY 2009-2010)
7. In almost 6-7 years’ deposit growth is much lower than the credit growth. This can be attributed to aggressive borrowing by the Telecom Companies & also aggressive borrowing by corporates at large before the Base Rate policy becoming applicable on August 01’2010
8. Even though there is merit in the argument that Short Term as an asset class has outperformed long term bonds or long term G Secs; there have been periods in which long end of the curve has hugely outperformed any other asset class including equities. Typical example is when we had recommended investment in long end in November 2008 & thereafter we had given an aggressive disinvestment calls between December 2008 end and January 2009 beginning by which time the investments in long term G Sec schemes had been hovering in the region of 20-25% absolute returns
9. Hence, even going forward, one will have to be nimble footed and take advantage of this trading zones which comes up every once in a while
10. I personally believe that we are in that trading zone range, wherein investors investing at current levels of 7.69-7.70% levels can expect, for reasons mentioned above, 10 year benchmark to soften further to between 7-7.25% levels by March 2011
11. One need not literally have one year view and hold onto these investments for one year. Investor need to cash onto these opportunities & redeem (even if there are exit loads applicable in some long term bond funds) as & when they have managed to earn more than expected returns from this asset class

Though short and medium term rates have not moved up today, the same will start inching up closer to dates of CRR hikes in February. Same will be the case when advance tax outflows kick in during March 2010. This is the time when yield curve will start to flatten from its current steepness (when 1-5 year yields will start moving up). Long end of the curve is (as expected) not likely to be impacted so much.

What were the key announcements & Forecasts?:

How does one read into RBI’s move of increasing CRR by 75 bps & not touching the benchmark rates?

What are the milestones post this Policy Review which can affect the debt markets?:

Hence, I see this Policy as a sigh of relief as immediate negative news is behind us (without impacting markets too much). Also this should give some insight into the mind of RBI (wherein they wish to see accelerated growth) & hence may not be in a real hurry to increase rates.

Impact of this liquidity tightness during February (when CRR hike takes effect) & advance tax outflows happen in March 2010, will be reflected in Short Term Plans for a short period of time. This asset class will have some negative impact before bouncing back post March 2010. On the other hand, if fiscal numbers for next year are on the positive side (with an assumption that RBI might not raise rates in hurry to achieve accelerated growth), long end of the curve should start rallying post March 2010. Another factor which can impact the long end positively is that Govt has almost finished their borrowing programme for the current year.