The Hindu Business Line : Higher interest rates are here to stay

So if you missed an opportunity to buy or sell and regret very hard having done so, the market will show you that level once again sometime. Most probably you will again end up doing what you did the first time.

The last time when the 10-year sovereign yield touched 6.70 per cent and then collapsed all the way to 6 per cent, many of the traders, including me, regretted not having bought bonds at the 6.70 per cent levels.

In retrospect, the market looked like such an obvious buy at those levels.

Even with a fifty basis point hike in the repo rate, 6.70 per cent looked like a good level for ten years. So we promised ourselves that we would really tank up on bonds if for some reason yields went back up.

The `Wish God' has granted us our wish, 10-year yield is back at 6.70 per cent and I cannot see a single buyer in the market.

Maybe 6.80-6.85 per cent for ten years is still a good buy in the short term, more so if the central bank does not move on rates in the forthcoming mid-term review. But one cannot say the same in the medium term.

As it was impossible to call the bottom on rates in the last four years when rates were coming down, it's virtually impossible to call the top as well.

There are enough negatives for interest rates in the medium term. The economy is growing at a fast pace, real GDP has grown on an average by 8.7 per cent in the last four quarters.

There has been a clear revival of the capex cycle, the capital goods sector has shown a growth in real terms of 14.7 per cent in the April-July period after having grown by 10.5 per cent and 13.1 per cent in 2002-03 and 2003-04 respectively.

We have seen a stupendous growth in credit in the last few months and one gets a feeling that it is only going to expand further.

The table gives you the three-month rolling average of inflation in manufactured products in the last one year. I have not included primary articles and fuel inflation in this as those can broadly be termed as `supply side inflation'.

Looking at the year-on-year number also does not make sense, as the horizon becomes too large. A three-month rolling average tells you how the prices of manufactured products have grown in the last three months.

As you can see, the manufacturing inflation was growing at 3-5 per cent between September 2003 and January 2004. It picked up momentum after that and grew at almost 8 per cent for the next three months after which we again saw a brief slowdown in the momentum.

The momentum has again built up over the last three months and given the sharp rise in commodity prices in the overseas markets last month, it is unlikely to slow down in a hurry.

The banking sector has been given a one-time reprieve by the central bank; it has allowed them to transfer large chunks of their bond holdings from their `mark-to-market' books to the `held to maturity' category.

In other words, it has insulated them from further mark-to-market losses. In an environment where credit is growing at a fast pace, the interest rate outlook is uncertain, banks have already booked losses on their bond portfolios and the Finance Minister is explicitly asking them to reduce their exposure to sovereign bonds and lend aggressively; we are quite unlikely to find many buyers of bonds.

Investor banks have lately shown complete apathy and there has to be a very good reason for them to come back to this market.

Even the Federal Reserve seems determined to take interest rates higher in the US.

The way the Fed Governors have been speaking lately, if the GDP continues to grow at 3.5 per cent you could see the Fed funds rate at 3 per cent over the next one year.

Most of the bond houses in the US earlier were calling for the Fed stopping at 2 per cent.

The 7.38 GoI 2015 auction on Monday should do very badly. Even at 6.90 per cent, I don't see full subscription.

The 6.90 per cent for 11 years is a good level to buy if one is sure that the RBI is not going to hike rates on October 26.

We could see the 10-year yield back in the 6.25-6.50 per cent range if there is no hike in the policy.

But it's a difficult call to make.

Although there has been a slight shift in the RBI viewpoint on inflation, I still can't take a view on whether they will hike the repo rate in the forthcoming policy review.

They have moved from an earlier stance of almost all of the inflation on account of supply side factors to some of it on account of demand-pull.

The overall economic and inflationary outlook gives me conviction that they are surely going to move on rates by January but I will not be surprised if it's sooner than that.

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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Higher interest rates are here to stay