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Monday, May 10, 2004

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Bond markets in for some volatility

Pranav Thakur

The Fed will be extremely cautious while raising rates as it will not want to risk thwarting an incipient recovery.

THE recent spate of strong data in the US has left almost everyone convinced that a hike in the Fed funds rates is imminent.

The timing and the extent is anybody's guess, but it looks like it will be sooner than later. In its statement though, the Fed has said that the hikes will be measured. So may be it will initially hike rates in baby steps of 25 basis points. If the economic numbers continue to be as strong as they have been, we should see the Fed move to a neutral Fed funds rate over a period of time. There are various views on what the neutral rate should be, but by reading various points of view one gets a feeling that it should be somewhere around three per cent.

All said and done, Fed will be extremely cautious while raising rates as it will not want to risk thwarting an incipient recovery. Any sign of even a small dip in economic activity will make it go slow, more so because fuel prices are already at sky high levels. As we are all aware, fuel is an important component of all manufacturing activity and high cost of fuel is by itself a tightening of sorts.

In the past, we have seen slowdown in economic activities, post sharp jump in oil prices.

The 5-year USD swap rate has moved up by almost 150 basis points from the lows that we saw after the February non-farm payrolls data. It has moved from around three per cent to 4.5 per cent in the last one month.

If the Fed has to move from one per cent to three per cent over the next year or so, then is not a large part of the Fed hike already priced in for now? May be the short end has some further room to move up.

What does the US interest rate environment entail for Indian bonds? Clearly, the bond traders are weary and most of them have already sold out. The market is technically light and it is unlikely that we shall see much selling from the traders as they do not have much left to sell. So the big question then remains is what are the investors looking to do. Given the liquidity, it is unlikely that they will sell in any significant way unless the RBI changes its monetary policy stance as well.

In the current environment and especially if the NDA comes back to power, a change in the monetary policy outlook of the central bank looks less likely.

There may not be much upside on the bonds but at the same time for factors mentioned above, there may not be much of a downside as well. One would get some trading opportunities through the next couple of months.

Even if the local interest rate environment changes a bit, it will always lack the viciousness of the US market. More so because with Fed funds rate at one per cent, the Fed has had an ultra accommodative monetary stance till now, so naturally it has more unwinding to do than the RBI. And if for some reason the US economy starts losing steam and the Fed has to abandon tightening, that will have a positive impact on the Indian market and bonds here will rally too.

In this scenario, it might make sense to put on a risk neutral dollar liability and a rupee asset. If one chooses one's level for entering into this trade and times it well, it is unlikely that he will lose much money.

The rising interest rates and the new found strength of the dollar against major currencies could impact flows into the country in the medium term, but not significantly enough to change the over all outlook on the rupee. Over a period of time, we should see the NRI and FII flows slow down a bit as a part of this money should start chasing dollar assets. But the country's current account surplus and the FDI inflows will ensure that the rupee continues to strengthen.

It is just that the pace of increase in the RBI foreign currency assets will temper. However, position unwinding could cause some interim volatility.

(The author is a Senior Trader, (interest rates), at HSBC, Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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