The Hindu Business Line : Hawkish Fed minutes, euro selloff

In fact, the poor liquidity of 9.39 security, post the auction, gave the impression that traders were hardly holding that stock and almost all of it had moved into the hands of the investors.

EVEN a sharp fall in the headline inflation failed to please the market and we saw a broad-based selloff after the number came out on Friday.

Though the medium-term outlook on rates is still far from positive, personally I thought the short-term positives could push up bond prices temporarily.

Liquidity was comfortable; the auction of 9.39 GoI 2011 had seen a tremendous investor response and inflation had fallen sharply to 5.78 per cent from the highs of 8.74 per cent that we saw in August.

In fact, the poor liquidity of 9.39 security, post the auction, gave the impression that traders were hardly holding that stock and almost all of it had moved into the hands of the investors.

Almost all metal prices had collapsed, thereby, making the inflation outlook further benign. But a string of negatives have made the market extremely cautious.

First off the block was the hawkish Fed minutes. It said that the current Fed funds rate was not capable of fighting inflation. You don't have to be a trained economist to figure out that 2.25 per cent is a rate quite low to fight inflation in any meaningful manner.

Nowhere did it mention that inflation was actually becoming a threat and that there was an impending need to fight it. But the markets across the globe got cautioned and we saw a big sell-off in the euro.

It seems the whole trading fraternity was sitting long euro and short dollars on the back of large twin deficit of the US.

The Fed minutes triggered the unwinding of this position.

To start with it caused the rupee to weaken a bit and among other things, it made the domestic stock market jittery, which had anyway gone up too much too soon.

Unlike the developed markets, for some reason a weak stock market has always made the bond traders nervous here whereas the vice-versa may not be true.

It might have something to do with the deeply embedded fear of a run on the rupee on account of FIIs pulling out.

A rather deep correction in stocks took out the momentum that was building in the bond market in anticipation of the sharp fall in the headline inflation. And to top it all, crude prices started inching up again.

The US bond market till now has looked at crude prices in a completely different way as compared to us.

Any sharp jump in crude has caused a rally in their bonds as they look at it as a tax on the economy.

Higher oil price is lower economic growth for them. But we have traditionally looked at higher crude prices as the paramount threat to inflation and hence any jump in crude oil prices has always caused the bonds to sell off here.

A gradual inch up in crude prices over the last 2-3 days has only increased the bond apathy.

OIS (overnight index swap) rates for some reason have been one way since the beginning of the year.

We have seen small rallies in bonds in the New Year but OIS rates have been slowly and surely inching up.

OIS in the past has been a great indicator of market sentiment and there is no reason to believe that it will not be this time. Looking at its behaviour, one can safely say that the market is far from bullish.

Most of the traders have sold out and are sitting on marginal positions, any bit of positive news can cause bond prices to gap up.

The market is vulnerable to some positive news at this time but looking at the broad trend, the bullishness might be short-lived.

Sooner or later, the market will again start focussing on the scheduled auction in the first week of February.

At this point, I cannot see much appetite for long-end paper. The 10-year segment might suffer the most on account of the auction.

Moving out of 7.38 GoI 2015 and into 7.55 GoI 2010 should to be the flavour for the next week.

Although core liquidity is to the tune of Rs 19,000 crore as of now, a large part of it might get drained out over the next couple of months.

The last quarter of every year has traditionally seen large currency expansion. Coupled with the credit growth that we are witnessing, it can cause a sharp drop in the liquidity of the system going ahead.

Looking at the banking system's credit-deposit ratio of 1.94 this year, it is unlikely that investor banks will come in to buy bonds in a big way.

Moreover, the market will be particularly nervous going into the Budget fearing a hike in the EPF rate to 9.5 per cent.

I think that we will finally end up having two slabs of 8.5 per cent and 9.5 per cent depending on the level of contribution, but the market will always fear the worst.

On the whole, rates look range-bound with a bias to move higher.

(The author is 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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