The Hindu Business Line : Medium term outlook on rates still negative

According to a senior Finance Ministry official, the calendar is expected to be front-loaded, which means that the government shall endeavour to borrow more in the first half of the year.

MONDAY will most likely bring the auction calendar for the next six months, which in turn will decide where interest rates are headed in the short term.

Clearly, the bond market is sitting light and a soft calendar for April is sure to cheer the bond bulls. The budgeted net borrowing through dated securities for 2005-06 is Rs 1,03,000 crore.

According to a senior Finance Ministry official, the calendar is expected to be front-loaded, which means that the government shall endeavour to borrow more in the first half of the year.

In the light of this information, I think it is reasonable to expect a net borrowing of Rs 55,000 crore in the first six months.

Bulk of the maturities in 2005-06 also happens to be in the first half. Out of a total of Rs 34,000 crore worth of dated securities maturing in the year, Rs 30,000 core mature in the first half.

Adding this number to the expected net borrowing of Rs 55,000 crore, the gross borrowing for the first half comes to an astounding Rs 85,000 crore. This number is undoubtedly large and is sure to hurt bonds.

However, we could see a number much smaller than that in the final tally.

Using a similar methodology as above, the first half borrowing number for 2004-05 should have been Rs 80,000 crore whereas it came out at a meagre Rs 59,000 crore.

The reason behind it was the huge cash surplus that the government had managed to build up at the end of last year.

It is difficult to estimate what the cash situation of the government will be as of the close of this year, but that number can significantly alter the gross borrowing requirement in the first half of next year.

A light calendar might cheer the market for a few days but the medium-term interest rate outlook continues to be negative. Commodity prices, including crude, are still hovering around their all-time highs. US interest rates have climbed quite significantly last month.

More so after the Fed for the first time in the last few years talked about the existence of some inflationary pressures in the short term. Looking at its stance, it seems that Fed is not going to stop hiking rates till the rate reaches close to 4 per cent.

Most of the hikes going ahead should be in baby steps of 25 basis points in every meeting, but I won't be surprised to see even a fifty slipped in, depending upon the data at that time.

In spite of the factors mentioned above, as of now I will not ascribe a probability of more than 25 per cent to the possibility of a rate hike by the RBI in April.

More so, because on occasions more than one, the Finance Minister has said that local rates will not rise for the next six months.

One can justify `a no rate hike scenario' for now because domestic inflation has been subdued for some time.

If for some reason that happens to turn, given the global rate environment, it will be very difficult for the central bank to stop itself from hiking rates again.

Even if the central bank does not hike rates in its April policy, the fresh borrowing by the government and the MSS maturity replacement will make sure that rates continue to slowly drift up.

Thanks to the bunched-up capital flows, RBI has had to buy huge amounts of dollars in the last two months which has dramatically pushed up the liquidity in the system.

With capital flows slowing and the trade deficit widening sharply, it is unlikely that it will have to continue to support the dollar.

A slowdown in liquidity build-up is also likely to hurt bonds in the future. Any blip up in inflation and you will see the central bank attack the liquidity sloshing around.

Over the last few years, we have seen a secular trend in terms of the flattening of the yield curve, especially in the 5 cross 10-year tenor of the GoI curve.

Many market participants, including us, have been calling for the curve to steepen for quite sometime now.

The 5 cross 10 has indeed steepened by almost 7-8 basis points in the last ten days on the back of the auction calendar expected to be full of longer dated issuances.

The table will, however, tell you that at least the issuance trend in the last four years does not really say so.

As you can see, the government has clearly moved away from its earlier policy of issuing almost everything in the longer term.

It has increasingly started relying on floating rate notes and medium term bonds to fund itself, which will clearly make the steepening difficult.

(The author is a senior trader with HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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