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US Fed Rocks Indian Market

The alarm bells rang in the US markets when the Fed unexpectedly dropped its pledge of keeping a low interest rate. Indian bond markets also reacted negatively to it, and bond prices crashed. Inflation, however, came down after a long time.

Indian bonds took a beating this week after the US Federal Reserve unexpectedly curtailed its commitment to low interest rates. The yield on the 10-year benchmark (GOI 2014, 7.37%) jumped to touch a one-and-a-half month high of 5.19 per cent on Friday – up 6 basis points over the week. Though liquidity in the market was comfortable and the inflation came down after nine straight rising weeks, the market sentiment turned negative.

In 2003, the US Fed had said that the interest rates could well stay low for a "considerable period" of time. But the Fed no longer wishes to be bound by that wording and has dropped that pledge. As a result, the yield on the 10-year US Treasury note rose to 4.17 per cent from 4.04 per cent on the announcement day – January 28. Though the Fed has kept the benchmark federal funds rate unchanged at 1 per cent, the change in its tone suggests that an increase in rates is on the offing. This reversal in US interest rates could well lead to a slowdown in foreign capital inflows, thus affecting liquidity and may result in hardening of bond yields in India.

Inflation, however, dipped to 6.13 per cent for the week ended January 10, thus halting the nine consecutive weeks of rising trend. In the previous week, inflation had touched a 39-month high of 6.21 per cent. Since inflation is given more weight in India compared to the US interest rate, a higher inflation in recent times is of greater concern for the Indian bond market. However, RBI's recently published Report on Currency and Finance stated that inflation may not attain a downward bias, but the latest estimate of 4-4.5 percent by March-end continues to be relevant for policy purposes barring unexpected shocks.

The recent pick-up in non-food credit is also worrying bond investors. For the fortnight ending January 9, non-food credit rose by Rs 11,233 crore against a rise of Rs 4,686 crore one month ago. This clearly indicates that the expansion in the Indian economy is resulting in more spending and subsequently creating more demands for bank loans. Though this is a good sign for the economy, it may restrict RBI from softening interest rates further. The latest comment from the government that there is no plan to review interest rates on state-run small savings has also dampened market sentiment. Low credit offtake and the reduction in these administered rates were largely responsible for the bond market rally in the past two and a half years.

The liquidity in the market, however, edged up dramatically this week, with the daily average subscription to RBI repos touching Rs 34,000 -- a rise of 40 per cent over previous week. The call rate too remained below the repo rate of 4.5 per cent. The increasing forex inflows and the recent currency rating upgrade by Moody's and Fitch resulted in the rupee touching a 12-week high of Rs 45.30/$ on Friday -- a gain of 5 paise over the week. Moreover, India's foreign exchange reserves rose to a record high of $104.24 billion in the week ended January 23.

Outlook
Bond yields are expected to remain at the current level, with an upward bias in the near term. All eyes will be set on the inflation number and the vote-of-account scheduled in the coming week. The NDA government will present the interim Budget on February 4, ahead of the dissolution of the Parliament (on February 6).