The Hindu Business Line : Yields continue to climb on inflation woes, rising oil prices

Global oil prices hit a record $110 a barrel, triggering a scramble for forward cover by large importers. In fact, importers had so far stayed away from making any forward covers anticipating a reversal. But with oil companies picking up greenbacks even at Rs 40.6 per dollar, they appeared convinced of a further deterioration in the exchange rate.

As a result, importers and corporates with external debt service liabilities quietly began taking cover during the week. Forwards returned to a premium over spot.

Forwards were at a discount during the last consecutive three weeks. One month premium was 1.78 per cent (-1.48 per cent), three months 1.48 per cent (-0.79 per cent), six months 1.29 percent (-0.29 per cent) and 12 months 1.04 per cent (0.10) per cent.

But liquidity conditions are likely to ease, traders said. This is partly in anticipation of arbitrage inflows into the country.

The possibility of arbitrage flows heightened after the Federal Reserve Board fixed a floor rate of 2.39 per cent for its 28-day $50 billion liquidity support through the Term Auction Facility on March 10. The stop out rate, the lowest cut-off rate accepted, was 2.80 per cent.

In addition, Fed has also put in place another $200 billion for liquidity support — Term Securities Lending Facility or TSLF. This is essentially loaning treasury securities against AAA rated bonds and mortgage backed securities as collateral.

The moves drove down the message of even lower dollar rates. In fact, the trigger for lower rates sparked off a scramble among arbitrage traders. The opportunity was in the form of lower dollar borrowing rates and higher returns from emerging market securities, particularly Indian securities.

LAF auctions

Bankers said that some flows were taking place into the Reserve bank’s reverse repurchase window. This was apparent from the recourse to the RBI’s liquidity adjustment facility auctions. The second LAF auction was put in place for flattening spikes anticipated due to advance tax outflows.

However, at the LAF auctions on March 14, the flow was more into the reverse repurchase window, indicating that arbitrage traders were active. The arbitrage traders would be earning at least 3 per cent spread in the process.

Reverse repurchase implies RBI sale of securities for mopping up liquidity. At the two auctions, the net recourse to the reverse repurchase window was Rs 5,570 crore. Traders said it was mostly foreign banks that took recourse to the reverse repurchase window.

The trend of this variant of the currency carry trade, was also partly responsible for altering the forward discount back into a premium.

The developments provoked the RBI Governor, Dr Y.V. Reddy, to react. The RBI Governor indicated that widening spreads between the reverse repurchase and the repurchase facility would be an option before the RBI to contain liquidity flows. The message was loud and clear. Reverse repo rates, currently at 6 per cent, could be cut without a change in the repo rate of 7.75 per cent. This was essentially to bottleneck arbitrage inflows. But accretion to liquidity during the week was also from coupon flows and redemption of Market Stabilisation Scheme (MSS) securities.

MSS redemptions amounted to Rs 4,571 crore. In addition, there were coupon flows amounting to another Rs 1,500 crore. The flows ensured stability at the weekly Treasury bill (T-Bill) auctions.

At the 91-day T-bill auction, the cut-off yield was 7.39 per cent, unchanged from the previous week. As against the notified amount of Rs 500 crore, the mop-up amounted to Rs 700 crore, inclusive of the Rs 200 crore from non-competitive bidders, mostly States and funds. At the 364-day T-bill auction, the cut-off yield was 7.44 per cent. The net liquidity injection, after redemption and coupon flows was Rs 3,500 crore.

The liquidity injection partly prevented a sharp rise in the 10-year yield to maturity (YTM). On a weighted average basis, the ten year yield to maturity rose to 7.61 per cent last week-end, only three basis points above the previous weekend.

The undertone remained depressed. Average daily trade volume remained low at around Rs 5,500 crore. The low trade volume was also largely on account of the absence of insurance companies, particularly the Life Insurance Corporation of India. Besides, the inter yield spreads were also narrow. The spread between the 91 day T-bill and the 10 year security was 21 basis points. Between one and 28 years, the spread was 63 basis points, indicating a flat yield curve.

One reason for the flat yield curve implied a slack in credit off-take and portended a slowdown in the economy. But the single factor worrying bankers was the ascent of inflation combined with a slowdown.

Inflation is currently at 5.11 per cent well above the RBI’s target. But the one-year real yield was down to 2 per cent, close to internationally accepted levels. The credit growth since the beginning of this year was 16.7 per cent, lower than the deposit growth of 18.1 per cent. Even this credit growth was partly on account of refineries drawing down on their lines for funding oil payments.

The outlook though remained stable. The Bank of Baroda’s chief economist, Dr Rupa Rege Nitsure said, “Inflation is a major worry. But the ten-year yield will remain ranged at 7.8 per cent.”

The reason for the stable outlook is the liquidity overhang in the banking system. The overhang is evident from the outstanding MSS securities. Outstanding MSS as on March 07 this year was Rs 1.72 lakh crore as against Rs 49,728 crore during the corresponding period of the last financial year.

Besides, cash balances with the RBI since the beginning of this year are Rs 74,000 crore, about three times more than it was during the corresponding period of last year. For the next financial year, the estimated MSS security float expects Rs 2.47 lakh crore.

Consequently, MSS interventions imply the resolve to contain inflation, implying interest rates are unlikely to show any major retreats. The good news is that rates are also unlikely to show any major increases.