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Rally Slows Down; Market Awaits Rate Cut

The rise in demand for credit is baffling since it comes amidst talks of an industrial slowdown and sluggish economy

The unrivalled bull-run is finally showing some signs of fatigue. Fears of fresh auctions, volatile oil prices, FITCH downgrade and advance tax outflows are keeping players on the sidelines. After two months of consecutive rise, the JP Morgan G-Sec Index lost a quarter of a per cent in the current week. The market has already factored a 50 basis point cut in the bank rate and now expects the apex bank to usher in lower interest rates by the end of the month.

The economy is sluggish with industrial production down to 1.3% YOY in March 2001 while exports have decelerated to 5.5% YOY in April 2001. The slowdown is also evident in diesel consumption and non-oil imports. Yet, amidst the gloom, it is baffling to note that non-food credit has actually gone up by Rs 4,800 crore for the current fiscal (till May 18) against Rs 1,943 crore during the same period in 2000. The acceleration in credit growth is contradictory to the belief that the economy is on the downhill. The source of demand is surely the crucial question. On the other hand, with a lacklustre investment environment, there has been a sizeable jump in bank deposits. This partly explains the surfeit of liquidity in the system and soft interest rates despite the surprise pickup in demand for credit.

The beginning of the reporting fortnight saw a firm trend in call rates, which breached the 8% barrier, as banks borrowed to cover their positions. Public holiday, repo auctions and RBI's open-market operations further accentuated the demand for funds. Reflecting the tightness, the RBI pumped in liquidity through reverse repos for the first time since May 23. Some players also borrowed at the backstop facility rate of 9.5%. On the other hand, gilt prices recovered towards the end of the week, buoyed by the appreciation in the rupee that bounced back to close at 46.95/$. The domestic currency propped up on the back of strong dollar inflows and a marginal recovery in oil prices.

Outlook
An auction is expected next week though the quantum may not be large due to advance tax outflows from June 15. The government may also opt for a private placement. While most players have covered their position in the run up to reporting Friday, any sizeable outflows could push up call rates. The market is currently in the overbought zone and any rise from current levels is likely to be interspersed with bouts of selling.

While the market has discounted a 0.5% cut in bank rate, a larger than expected cut or a further reduction in repo rate could fuel a strong rally. On the other hand, the sentiment could start to turn jittery if the rate cut does not materialise in the near future.

Meanwhile, even as oil prices have come down below $29 per barrel, they are still not out-of-the woods. With OPEC deciding not to increase output, any short-term spurt in prices could be a setback to the fragile markets.