The Hindu Business Line : Yields up on tight liquidity; may remain ranged till year-end

Traders said the spectre of more sub-prime casualties was slowly emerging, the latest one being Wachovia, the world’s fourth largest bank. Wachovia has reported a sub-prime loan write downs of about $1.1 billion.

But bankers are expecting more loan losses worldwide. In fact, the Federal Reserve has been accepting mortgage-backed securities for bailing out troubled banks.

On November 16, the New York Federal Reserve carried repurchase operations of over $28 billion. Of these, at least $3.7 billion was in the form of repurchase of mortgage-backed securities.

But the Fed’s infusion has conveyed the impression that liquidity support would continue for some more time and interest rates would be allowed to soften, despite financial market troubles. As a result, inflows into the domestic markets from foreign institutional investors gathered pace.

Last week, there was a net inflow of at least $200 million. Bankers said part of the flows was closely related to conditions in the global oil markets. Global oil markets weakened as hedge funds pulled away from hugging the $100-barrel mark and moved back into emerging market financial assets. Global oil prices dropped to about $91 a barrel.

However, oil companies’ rush to take advantage of the reversal in oil prices marginally pulled down the rupee. The rupee dropped to Rs 39.35 against the dollar, as PSU oil companies took advantage of the firm exchange rates.

Softening premia

Yet, bankers said that a firm rupee was far from over. This was evident from the softening forward premia. Forward premia for one month was down to 1.3 per cent. Three, six and 12-month premia were down to 1.42, 1.43 and 1.17 per cent respectively. The drop in premia at the long end was partly led by exporters and foreign direct investors resorting to long-term hedges.

PSU oil companies are not allowed to hedge, though private sector refiners in the past have hedged their currency exposures and commodities. PSUs are likely to push for such hedges. At current prices, none of the companies are hedging.

The drawdown in credit lines by PSUs led to liquidity tightening, which prompted banks to take recourse to the repurchase window. At the week-end repo auction, 28 banks/PDs accessed the repo window for Rs 28,000 crore. Part of the tightening was triggered by arbitrage opportunities that came up on high call rates.

Call rates were close to nine per cent, throwing up an arbitrage opportunity for banks. Another small part of the repo access also stemmed from redemption of bulk deposits by corporates.

The tight situation pushed up the yields at the weekly Treasury Bill auctions. The yield on the 91-day T-bill rose to 7.51 per cent. The weighted average yield was 7.48 per cent. Bids, both competitive and non-competitive, amounted to Rs 7,063.17 crore, though only Rs 3703.17 crore was accepted. At the 182 T-bill auction, the yield was 7.60 per cent.

The tightening ensured that the ten-year weighted average yield to maturity (YTM) remained unchanged at 7.94 per cent, as in the previous week. The undertone was positive though not bullish. This was evident from the improved daily trade volume that rose to about Rs 4,100 crore last week. The previous daily average volume was about Rs 2,700 crore. However, T-bills and short-dated securities comprised at least 50 per cent of the trade volume.

Outlook mixed

But the outlook was mixed due to foreign capital inflows and oil driven liquidity demand.

The mixed outlook was evident from the narrow inter yield spreads. The spread between the 91-day t-bill and 10- year YTM was barely 50 basis points. Besides, the bid-offer spreads at the short end, between one and 5 years, was only 10 basis points. For securities with maturities between five years and 29 years, the spreads were as high as 20 basis points.

The high spreads at the long end were clearly indicative of the low interest in long dated securities. Insurers, especially the LIC, did some switches, swapping short dated securities like the 9.39 per cent 2011 for the 8.33 per cent 2036. Traders said the volumes in these deals were low, ranging from Rs 50 lakh to a crore.

Bankers said that yields are likely to remain ranged for the rest of the year. Said Mr Moses Harding, Executive Vice-President of IndusInd Bank: “A best case scenario is a 10-year YTM at 7.75 per cent. In the worst case, it will be 7.95 per cent.”

Moreover, the liquidity overhang was likely to continue through the next few weeks, powered by accelerating capital inflows. Despite the liquidity impact, few expect interest rates, either the repo or the reverse repo, to change. This was despite inflation remaining well within the targeted 5 per cent. With inflation currently at 3.11 per cent, one-year real yield is currently at 4.6 per cent.

Yet, the high real yield had little impact on money supply growth. Broad money supply continues to grow at 22 per cent ahead of the targeted band of 15-17 per cent.

Consequently, the RBI intervention for reining-in liquidity was likely to be in the form of tweaks to the Cash Reserve Ratio, that is currently at 7.5 per cent. But more such hikes are unlikely to prompt banks to push up lending rates.

This was because credit off-take still remained sluggish despite the peak season kicking in. Incremental credit deposit ratios were under 50 per cent. But deposits were being pruned, and more rate reductions planned for the coming months.

The deposit rate reductions were partly intended to decelerate accretions to NRI deposits. NRI investors have flocked to take advantage of high domestic rates and firm exchange rate. Also targeted are short-term deposit rates.

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