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Fund Managers Commentary
July 31, 2010
Debt Market
The RBI raised the reverse repo rate by 50 basis points and the repo rate by 25bps in its policy review on July 27, 2010. This was on top of a 25 bps hike it announced on 2nd July 2010, taking the total hike to 50 bps in Repo and 75 bps in Reverse Repo in the month of July 2010. The reverse repo hike was higher than expected, as the RBI reasoned that by narrowing the reverse repo/ repo corridor they wanted to ensure pass through of monetary policy in times of easy liquidity. The RBI also mentioned that liquidity will be neutral to tight in the near term, and that the repo window is more likely to be used due to tight liquidity conditions. Higher than the expected rate hike and also very hawkish post policy comments from an RBI official on interest rates being too low given that inflation is at double-digit levels increased expectations of rate hikes in September and October (mid-policy review and policy review), leading to upward movement of yield curves across the government bond market, corporate bond market, interest rate swap market and the money market.
The yield on the 10 year bench mark security which was in the tight range of 7.55-7.65% during the last month, surging up to close the month at 7.80%, an increase of 25 bps compared to previous month closing. Tracking the weak government bonds, the corporate bond yields too moved up on tight liquidity and rate hike worries. Five- and 10-year benchmark bond yields edged higher by around 15bps at 8.50% and 8.80% respectively.
The liquidity in the system remained tight for the entire month. The liquidity support provided by RBI averaged around 46K. However, towards the end of the month, the liquidity position eased considerably on proceeds from bond redemptions, and also due to technical factors like banks having covered CRR product in excess of their requirement in the first week of the reporting fortnight. We expect the liquidity will go back to being tight on fresh product covering and on auction outflows and hence the overnight rates may hover around repo rates at 5.75% levels.
Due to tight liquidity and the higher than expected rate hikes, the money market rates hardened considerably. The 1 year Treasury Bill rate moved up by 65 bps compared to previous month, to touch 6.20%. The 3 month CD and CP rates closed the month at 6.75% and 7.25%. Overnight index swaps (OIS) saw the curve move up on tight liquidity and rate hike worries. The five-year OIS yield closed up 64bps at 7.28% levels while the one year OIS yield closed up 90bps at 6.37% levels. The one-over-five spread moved down by 25bps at 91bps levels compared to previous month. The curve will remain pressured on liquidity and rate hike worries.
Inflation measured by the widely-tracked wholesale price index touched 10.55% for the month of June. The rise in inflation was led by primary articles up 16.3%, fuel up 14.3% and manufactured products up 6.7%. Similar to the upward revision to the March data last month, April data saw a revision from 9.6% to 11.2%. A key concern is the continued uptrend in non-food manufactured products inflation from 0.8% in Dec to 7.3% currently. We expect inflation to moderate in the coming months as the base effect turns favorable. Industrial output data released for the month of May 2010 surprised consensus on the lower side. The industrial output expanded by 11.5% YoY, the slowest such pace of growth since October 2009 compared to the consensus estimate of 16.20%. Manufacturing output growth slowed to 12.3% while mining growth slowed to single digits for the first time since October.
Going ahead, the market may remain weak, in anticipation of further rate hike and the tight liquidity condition. However, on the positive side, the bond yields across the globe are softening, as global markets brace themselves for slowing economic growth. Another important factor that may change the present bearish sentiment in the market is, the supply factor, as large part of the government borrowing completes for the first half of fiscal 2010-11 by the end of August and the market starts speculating on the reduction in government borrowing programme for the second half of fiscal 2010-11.These factors, coupled with any favorable impact of monsoon on inflation may trigger a rally in the market, as the yields are trading at attractive levels, from a medium term perspective.