The rapid rise in interest rates over the past six months has come as an unexpected bonanza to fixed income investors. Interest rates on safe options such as fixed deposits and bonds have turned quite reasonable.

State Bank of India's rates on one-year deposits today are at 8.25 per cent, having risen a whopping 2.25 percentage points since August 2010.

So, should you make the most of this rise and lock into long-term debt options? Or will interest rates rise further in the months ahead? That depends on what kind of investor you are.

Long-term rates to stabilise

Let's look at the outlook for interest rates first. Interest rates, especially on long-term options, could rise marginally or even flatten out at current levels due to three reasons.

One, inflation, the key trigger for rate hikes is showing early signs of moderation. Two, the Budget estimates suggest that government borrowings may not be as large as originally expected. Three, rising rates have helped banks attract record deposit inflows over the last couple of months.

Sticky deposit rates

The interest rate that your bank offers on your deposit seldom moves up or down as fast as market rates. This makes deposit rates ‘sticky'. Case in point: In the eight months from September 2008 to April 2009, as the liquidity crisis eased, the benchmark interest rates (RBI's reverse repo or repo rates) fell by a whopping 5.75 percentage points.

During the same period, one-year deposit rates for SBI fell by only 3.75 percentage points. As interest rates began their recent uptrend from March 2010, policy rates have gone up by 3 percentage points. Deposit rates of banks, however, began to climb much later and have only risen by 2.25 percentage points. Rates on one-year certificates of deposit (bulk deposits put in by companies have, however, shot up by 4.2 percentage points over the same period.

What this suggests is that, even if the RBI's policy rates were to rise by another 0.50-0.75 percentage points, deposit rates may not keep up. They may only increase by 0.25-0.50 percentage points for one-year maturity.

While this is the case for shorter-term deposits, longer-tenor (3-5 year) deposit rates may prove even ‘stickier'. Longer-tenor deposit rates during this interest uptrend have risen only by 1.25 percentage points; they may not rise much more than 0.25 percentage points from here.

Interest rates on short-term debt instruments look likely to cool a bit too, with easing liquidity.

Liquidity may ease

Bank deposit inflows over the last 3-4 months have been quite healthy, thanks to the above deposit rate hikes by banks. RBI data show net inflows of Rs 2.04 lakh crore into the bankers' kitty between December and February 2011, accounting for over a third of the year's inflows.

There are now signs that there could be a reprieve on liquidity too, as the amount banks borrow from the RBI's repo window has come down from over Rs 1 lakh crore/day in December to about Rs 80,000 crore in recent sessions. A deficit position of about Rs 30,000 crore is optimal. History also suggests that liquidity is typically in short supply ahead of March, due to the fiscal year close, advance tax payouts and similar factors.

Tight liquidity is also a function of the government being frugal with its spending. The government deposits with the RBI as of February 11 stood at Rs 47,202 crore, compared to just Rs 101 crore in the same time last year. (This huge jump was owing to the one-time revenues from the 3G auctions.)

The expectation is that the government may run down this cash balance, even as it receives fresh inflows in the form of advance tax payments. The surprisingly modest borrowing targets put out by the Budget too have lent support to the view that rates may not head up too sharply from here. From Rs 3.45 lakh crore in 2010-11, the Budget has indicated a borrowing of just Rs 3.42 lakh crore for 2011-12.

This estimate had bond prices shooting up on the expectation that there would now be enough liquidity to fund investments. However, the consensus view now emerging is that these market borrowing figures may be understated, given that the government has under-budgeted for expenses and subsidies.

However, a cooling off of oil prices from the exceptionally high levels, better than expected revenues for the government from divestments and other one-off sources, apart from any spill-over from the current fiscal, may yet temper borrowings.

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