The Hindu Business Line : Markets anticipating huge Govt spending

Traders said they preferred caution since the Monetary PolicyStatement failed to provide any major signals. Besides, statements being made by the coalition partners of the Congress-led Government also indicated that soft rate bias had almost ended.

What has also made traders nervous is the possibility of large-scale Government borrowings during the peak credit season driving up interest rates. This was because the Budget is likely to be placed only in July. What has also scared traders is the pullout by some of the foreign institutional investors. FIIs, in particular, hedge funds, are quietly beginning to exit from the domestic equity markets.

The exit is partly driven by international events - - the possibility of an increase in interest rates in the US and possible revaluation of the yuan.

The rising interest rates and changed risk perception in Asia in turn have triggered higher margin calls on the hedge funds. Consequently, these funds had reacted by selling some of their holdings.

Further, oil companies also reacted to the escalating prices in the global markets. Though liquidity has not yet tightened, incremental accretions to reserve money have clearly slowed down. There were signs of this trend in the RBI's weekend seven-day repo auctions. The mop-up of liquidity through these auctions fell below Rs 20,000 crore. Last week, it was about Rs 17,000 crore confirming that accretions had considerably dropped. Similarly, at the 91-day Treasury bill auctions, the yields remained at 4.40 per cent levels, both at the cut-off and the weighted average.

This was also because, some of the non-competitive bidders vanished. Non-competitive bids, which used to be almost equal to the competitive bids, were just Rs 256 crore. As a result, the 10-year yield to maturity remained almost steady at the low levels at 5.21 per cent on a weighted average basis last week. Coupon flows were approximately Rs 450 crore. But this trend notwithstanding, the undertone in the markets was weak. The weakness was evident from the steep drop in trading volumes. Daily trading volumes were barely Rs 3,500 crore. In fact, traders anticipate the weakness to continue for some more time. The outlook for the markets was signalled from the wide spreads between the one-year and 24 years. This spread was close to 160 basis points last week, up from the previous week's 149 basis points.

Further, traders said, the weakness in the markets was also contributed to selling by some of the life and general insurance companies. Among the companies that had sold securities was the Life Insurance Corporation of India. As a result, securities such as the 9.81 per cent 2013 have reappeared in the markets. Traders said that financial institutions sold G-Secs to support the equity markets. Large volumes of selling were also at the long end of the yield curve. In fact, most of the institutions that had bought heavily were all large sellers. Among the securities which showed sharp falls included the 8.35 per cent 2022 and the 6.17 per cent 2023, both of which fell by over 10 basis points in a week. Insurers are likely to remain sellers for some more time to support the equity markets, traders said.

The major factor that contributed to the nervousness in the markets was the direction of US interest rates. The yields on the 10-year US Treasuries at 4.69 per cent were already about 1.5 per cent higher than last year's levels. Similarly, UK Treasuries for ten years were also about 5.39 per cent, the highest level in this decade. Consequently, traders said that considering inflation differentials alone, G-Secs are likely to to rise further to match international levels or levels to reflect inflation expectations. Inflation in the UK is currently about 1.5 per cent, even after factoring in the current international oil prices. Inflation in India is currently at 4.2 per cent. Consequently, the real yield expectations were high. Real yield differentials, while remaining in the positive zone, were far lower than comparative international levels.

Besides, the deferral of some current and non-debt capital account remittances was yet another cause for markets to worry. Foreign currency inflows last week were barely $49 million, the lowest this year. Traders said that the major factor was the slowdown in non-repatriable rupee deposits by Non-resident Indians.

In addition, exporters preferred postponing their inflows in anticipation of a further weakening of the rupee against the dollar.

Already the rupee has dropped by about three per cent since the beginning of this year. But forwards continued to remain at a discount. This was partly because of the sell-buy swaps being undertaking by some of the banks in order to alleviate the spot dollar shortage in the markets.

The tightening has however, taken the load of the RBI. Traders said that the RBI abstained from the markets for most of the week, though had offered to sell dollars on Monday to meet the requirements, as a confidence building measure. Thetightening was evident from the widening spread differential between corporate and sovereign yields to over 50 basis points. For instance, the Power Finance Corporation 5.85 per cent paper ended the week at 5.71 per cent. In the case of the private corporate, the differentials were even higher, closer to 75 basis points above sovereigns.

Most of the corporates which had shown a preference for ECBs in view of the firm rupee and low interest rates are now expected to return to the domestic markets, paving the way for higher domestic rates. Along with this, huge Government borrowings may lead to further rise in yields.