The Hindu Business Line : It's still a toss-up on rate market trends

Last year, however, saw the rates move up comprehensively. We saw the 10-year govy rate move up from 5.14 per cent at the beginning of 2004-05 to 7.20 per cent by mid-November and then slowly drift lower to settle at 6.68 per cent by the end of the year.

So, there was almost always a trend of some kind, which seems to be distinctively missing this year.

This year, we saw rates move up initially. The benchmark 10-year govy rate moved up to the last year's highs only to come off sharply.

I accept that it is too early to say that unlike the earlier years, we might not have a trend at all. For all you know, we might. It's just that it is becoming increasingly difficult to spot one, and more importantly, its direction.

If you look at the economic fundamentals, almost all domestic factors seem to point at continued pressure on rates whereas the overseas economic environment looks like softening.

The euro zone is clearly in the midst of an elongated soft patch. Over the last couple of months, the pressure on the ECB to cut rates has increased immensely. The flat yield curve there conveys that the market expects the ECB to move left on rates if it moves at all. Even the data out of the US have been far from encouraging lately.

The Fed chief, however, has made it amply clear that the rate hikes at a measured pace will continue till such time as the desired neutral level is reached.

He does not buy the economic weakness story for now. It looks almost certain that the Fed is not going to stop till it takes thefunds rate to 3.50 per cent or even 3.75 per cent.

In this not so strong an economic environment, further rate hikes in the US can surely not strengthen its economy in any way. For all you know, it might cause some further softening. So, it seems quite clear that going ahead, the overseas economic environment will most likely be only a dampener for our domestic economy.

The domestic data, however, continue to be strong. After the usual contraction every April, credit growth seems to be back on track. After contracting by Rs 16,000 crore in April, commercial banks' non-food credit portfolio grew by a smart Rs 12,500 crore during May. The latest industrial production data are also quite strong. April saw the manufacturing sector grow by 10 per cent over last year. Inflation, on the other hand, seems to be moderating.

The primary articles and fuel inflation continue to be high in the last three months (primary articles inflation is seasonal), but the manufacturing inflation seems to be showing signs of slowing down.

In the last three months, the prices of manufactured products have gone up at an annualised pace of not more than 4.5 per cent.

Most importantly, the headline WPI inflation has dipped sharply on account of a large base effect and is expected to continue to do so in the coming months.

Even if inflation grew at an annualised rate of 5.5 per cent on a point-to-point basis from here, we could see the headline touch three per cent by September.

Although I have always maintained that tracking the headline inflation is not a very meaningful exercise, somehow it has become the single most important factor driving inflationary expectations.

No wonder, the RBI Governor has expressed his satisfaction on the inflation front, which makes me believe that we may not see a rate hike in July.

The news on the monsoons is far from encouraging. CMIE has already revised its GDP forecast lower to six per cent for 2005-06 based on fears of a failed monsoon.

If the monsoon does fail, it will only increase the uncertainties in the rate markets.

The market will fear a spike in primary inflation as much as a slowdown in domestic demand. The base effect will make sure that the headline inflation does not jump sharply even if primary article prices go up in the event of a failed monsoon.

In the light of this, a failed monsoon might just be positive for rates.

Clearly, there are two scenarios emerging with almost equal likelihood. First, the US starts to slow down with the euro zone thereby causing the Fed to stop hiking.

It will also help pull down commodity prices from the current dizzying heights which will then push domestic rates lower.

Second, the US continues to grow at the current pace, commodity prices continue to rule at high levels and domestic credit growth in the coming months ensures higher rates.

(The author is a 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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It's still a toss-up on rate market trends