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No Rate Cut Signal Dampens Sentiment.

Bond markets showed their ugly face with the apex bank stating that there is no interest rate cut in the offing.

RBI deputy governor, Y V Reddy finally took the bull by its horns on the Bond Street. His reported statement that there would be no cut in the bank rate sent prices crashing on Thursday. The yield on the benchmark 11.50, 2011 bond shot up to 9.61% after it had touched a new low of 9.20% on Wednesday. While prices dropped by as much as Rs 3 in a panic-stricken market, a late evening denial by the RBI helped bonds stage a marginal recovery. Clearly, the apex bank does not want a jittery market when it plans to rapidly finish with the government's borrowing programme. The shock wave could keep sentiment subdued for some time as an uncertain market gropes for direction on interest rates. In the last fortnight, there has been a flurry of statements from senior RBI officials, ruling out any immediate rate cuts. Yet, market players have shown scant regard and instead remained upbeat, virtually demanding a 50-100-point reduction by pushing down yields to historical levels.

The week also saw the open-market auction of 2004 paper to suck out excess liquidity in the system and garnered the targeted amount of Rs 5,000 crore. However, post-OMO, liquidity continues to be comfortable. Call rates, which remained at sub-7% levels, touched 7.25% in the closing sessions due to RBI's open-market operations. The rates could have been higher but for a thin demand just before the reporting Friday. The RBI's repo deal at 6.5% also drew a blank towards the end of the week as players expected higher overnight rates due to tightening of liquidity. With the OMO and downturn in sentiment, RBI may now wait for some time before testing waters with another auction.

Strong Measures Required
The market has been hoping for a rate cut since the economy has been going from bad to worse. The latest figures of industrial production ring alarm bells with the growth at a paltry 1.9 per cent for May 2001 against 6 per cent in the last calendar. Led by Federal Reserve, rate cuts have been the norm in 2001 as world economy slows down. However, after a 1% reduction in bank rate in the beginning of the year, RBI has doggedly refrained from a further rate cut.

While the government is now looking at fiscal stimulus to end the gloom, it should quickly decide on the measures to pep up the economy including disinvestment in PSUs. Infrastructure spending could be the key here, which can take off once the monsoon ends in September. The government spending, coupled with expected agrarian demand after a good monsoon, could trigger a turnaround.

Outlook
While NAVs of bond funds have dropped, the gains are still healthy with the average six-month returns at a whopping 8.47%. Hence, investors should stay put since there has been no change in the underlying fundamentals. With the sentiment derailed in the short-term, the markets could see some more selling before re-emergence of fresh buying and consolidation of prices. Though there are no apparent triggers, players are expected to pick up attractively priced bonds at the shorter end on the back of ample liquidity.

However, a run-away rally, as witnessed in the recent past, is now ruled out and activity at the longer-end of the G-Sec curve is likely to slacken due to the current uncertainty. On the other hand, the spread between gilts and triple A paper will narrow as gilt prices drop at a faster pace. The spread had widened to 120-130 basis points after yields on gilts touched unrealistic levels.

Last but not the least; pressure on interest rates can come only if credit off take picks up. However, if at all it happens, it is also a few months away.