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Cautious Markets Wait for Rate-Cut

The RBI had hiked interest rates in July last year due to narrowing differential between Indian and US interest rates. Going by the same logic, the current situation warrants an interest rate cut

The rampaging bulls were disappointed, as the eagerly anticipated bank rate cut did not materialise this week despite a 25 basis point rate reduction in the US. The sentiment was further dampened when RBI deputy governor, Y V Reddy ruled out any immediate move on rate cuts. He is reported to have said that the US Fed rate cut was only one of the closely monitored factors by the RBI. However, the lower than expected growth in gross domestic product (GDP) for 2000-01 re-kindled hopes for an early reduction in rate cut. The GDP expanded by just 5.2 per cent in 2000-01, sharply down from an earlier estimate of 6 per cent. This is also likely to impact the targeted GDP growth for the current fiscal.

The week saw the twin auction of 2011 and 2018 papers for Rs 6,000 crore, which attracted huge oversubscriptions on the back of ample liquidity. The RBI has now completed 47 per cent of the gross government-borrowing programme of Rs 1.19 lakh crore. With the cut-off yield for the 10-year paper at 9.39 per cent against the market yield of 9.51 per cent, it appears that the RBI is resorting to measures other than the bank rate to soften interest rates. The cut-off yield was also lower than the market expectation of 9.44 per cent.

Call rates hovered around 7 per cent for the week since most players had covered their positions before the reporting Friday. However, a late demand saw some deals stuck at 7.75 per cent. A huge deposit mobilisation with banks, return of advance tax outflows and redemption of government securities has only further pulled down overnight rates. On the forex front, a rock-steady rupee finally stayed below the 47 barrier for the entire week and closed at a new low of 47.05 on Friday. While the domestic currency has depreciated by 43 paise since the beginning of the current fiscal, it is still overvalued by 3 per cent against the dollar. It appears that the RBI is holding back the rupee since a sharp depreciation would mean costlier imports (including oil) and hurt economic revival.


Water, Water Everywhere But not a Drop to Drink

This adage sums up the current scenario in the domestic markets. While the system is flush with liquidity, funds are hardly been channelised to revive a sagging economy. In this backdrop, the onus now is on the government to take larger initiatives on the infrastructure front to trigger demand. While corporates have been raising money, it is primarily aimed at replacing high-cost debt rather than to undertake fresh investments.


Outlook

The RBI had hiked interest rates in July last year, citing the narrowing differential between Indian and US interest rates. Going by the same logic, the current situation warrants an interest rate cut since the difference between Indian and US rates has now widened by 325 basis points against 200 basis points in the beginning of 2001. Further, RBI has enough leeway to cut rates - inflation is benign, rupee is stable and globally lower rates mean a domestic reduction is unlikely to cut foreign capital inflows.

However, some uncertainty has crept into the markets on the timing of the rate cut. Players have been shifting from the longer-end to the medium-end of the yield curve and thus cutting portfolio maturity to guard against an event risk. Despite abundant liquidity, any negative development can trigger a sell-off since players have built positions in anticipation of a rate cut. With a sharp runup in gilt prices, the spread has again widened to 100-110 points between corporate bonds and government securities. Further, buying has also percolated to lower-rung papers. Thus, the coming weeks will see a renewed focus on corporate bonds.