The Hindu Business Line : Interest rates can move down too

The secular downward movement in interest rates in the last few years has made the market insensitive to the fact that there exist "interest rate cycles". If growth rates, inflation numbers and liquidity levels can move from one extreme to the other, so can interest rates.

OCTOBER 2003: Fuelled by years of steady southward yield movement, the market harboured expectations of yet another repo rate cut in the November 3, 2003 Policy which drove yields to all-time low levels. The ten-year benchmark yield touched 4.95 per cent amidst the buying spree with the market discounting a repo rate cut.

Since the market was not gifted a repo rate cut in the Policy, it quickly realised that the repo rate cut bonanza was through and the yields corrected, with the ten-year hovering around 5.25 per cent levels.

May 2004: The market expected nothing and got nothing in the May 18, 2004 Monetary Policy. The market had only liquidity, inflation numbers and forex inflows to look to for trading opportunities. The enormous system liquidity of over Rs 75,000 crore gave the market the audacity to trade at same yields in spite of the rising US rate scenario.

October 2004: A market that is saddled with painful MTMs (Mark to Market) of bond holdings and a CRR hike has started to acknowledge the fact that interest rates have started their northward journey.

The market, which had earlier speculated on the probability of a repo rate hike, has now started speculating on its timing and extent. The market-determined rates appear to have, in fact, discounted a rate hike to some extent. The move of the ten-year benchmark yield from 4.95 per cent to 6.85 per cent in less than a year without any change in the administered rates adds credibility to the argument.

The three basic factors the market would focus on to attain clarity on future direction of interest rates are liquidity, inflation and macroeconomic growth coupled with credit offtake.

The liquidity levels in the system have been receding in a sustained manner courtesy MSBs, vibrant credit offtake, CRR hike and less generous forex inflows.

Moreover, given the central bank's view that excess liquidity has played a serious role in generating inflationary pressures, the probability of liquidity being allowed to reach more than adequate levels seems miniscule.

Hence, the possibility of a CRR hike by the central bank cannot be ruled out. The average liquidity has dropped sharply from levels of over Rs 75,000 crore in May to around Rs 12,000 crore now.

Inflation numbers for the fiscal have zoomed way above the central bank's projection and could scale unmanageable levels if oil prices and manufacturing prices move up. The market gets some relief whenever the base effect is strong but the absolute index value has been inching up on a continuous basis which appears ominous and does not bode well for interest rates.

The last Monetary Policy, announced on May 18, mentioned that "the RBI will pursue an interest rate environment that is conducive to maintaining momentum of growth and macroeconomic and price stability."

The average inflation for that period (April-May) stood at 4.37 per cent, whereas the average inflation for the last two months has been around 7.9 per cent.

This means there has been a movement of more than 350 basis points. Considering that price stability has been and will continue to be a key objective for the RBI, it is imperative that this coming edition of the policy addresses this issue.

The growth statistics for the economy have been extremely encouraging with market expectations of a GDP growth figure of 6-6.5 per cent for this fiscal.

The quarter on quarter GDP growth numbers are also strong in spite of a high base effect. Since there are no signs of any slowdown, it confirms that the economy is cruising well on the growth track. Non-food credit offtake has shown a sustained rise and the increase has been more than Rs 76,000 crore since March end and approximately Rs 1,56,000 crore since October 2003. Such a sharp and steady rise in credit offtake signifies that the trend will continue.

It appears that the most fundamental economic equation of demand and supply appears to have undergone a radical change in the bond market. The demand side for bonds appears to have reduced dramatically in recent times. The primary reasons could be comfortably assigned to the rising bond yields coupled with a severe drop in the liquidity overhang and encouraging credit off take figures.

As per the RBI's annual policy statement for the year 2004-05 released on May 18, 2004 the banking system holds government securities to the extent of 41.5 per cent of its net demand and time liabilities (NDTL) as against the statutory minimum requirement of 25 per cent.

In terms of volume, such holdings above the statutory liquidity ratio (SLR) amounted to Rs 2,69,777 crore which is much higher than the annual gross borrowings of the government. With such an enormous amount of excess SLR already present in the system, the demand for SLR assets would be minimal.

Recent RBI statistics provide further strength to this theory which states that the SLR holdings of the banks are steadily decreasing and Non-food credit is continuously increasing. From August 6 to September 17, 2004 the SLR holdings of the banks have fallen by more than Rs 20,000 crore whereas the non-food credit has shot up more than Rs 31,000 crore.

If such a trend sustains it does project an extremely grim picture for the bond market as the market could well be on the threshold of a sustained upward interest rate movement.

Those banks which held excess SLR in the euphoria of abundant liquidity and the soft interest rate regime will now be looking to replace it with credit outflows. The appetite of the traders also has diminished significantly which can be easily gauged from the current market volumes. There are hardly any noteworthy inflows into mutual funds even at the present relatively high bond yields.

Short-term fund returns are not making the investor smile anymore and so floating rate funds have grown exponentially.

Even after a fair degree of rise in yields, bonds are being treated as "untouchables". Whereas the supply side would not fall as the government's borrowing programme would continue its scheduled course.

Moreover, if revenue receipts do not live up to the expectations and consequently revenue deficit shoots up, the supply side would increase further. Thus, the only way for this demand and supply equation to balance would be an upward trend in the interest rates.

The same Indian market that looked for clues in US interest rates with avid attention and talkeabout the global integration of markets when US rates were on the downslide, is now trying to alienate itself from the global set-up when the US is going through a rate tightening phase.

The reasoning is that local factors are the driving forces behind Indian interest rates. It remains to be understood on what logic the so-called "local factors" present a case for stable interest rates.

For interest rate traders who are looking to punt on where the interest rates will be two weeks from now, a question worth pondering over is: "Where would our interest rates be one year from now", when a high percentage of next year's government scheduled borrowings will be over. Would this market have a sustained appetite for SLR assets for such huge amounts at current yields next fiscal?

The secular downward movement in interest rates in the last a few years has made the market insensitive to the fact that there exist "interest rate cycles". If growth rates, inflation numbers and liquidity levels can move from one extreme to other, so can interest rates.

The market would continue to have intermittent rallies but the direction of interest rates appears to have reversed. It is worth remembering that all markets go through interest rate cycles, and it would be really difficult for the Indian market to be an exception.

(The author is in Interest Rate Trading, HDFC Bank Treasury. The views are personal.)

More Stories on : Interest Rates | Economy

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Ambitious on FDI

The world economic disorder

Stability of prices or inflation?

Endless tale of the essential onion

A poll tear-jerker?

Revitalise rural credit thru Nabard

Interest rates can move down too

V for Vijay Kumar

Presidential debates