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Bonds track forex market

Pranav Thakur

LAST month's interest rate hikes seemed to have had little effect on the forex market as the rupee continued its slide to cross the crucial 46-level last Friday.

The liquidity tightening measures had lost their impact thanks to incessant monetisation by the Reserve Bank of India. The Rs. 9,000-odd crores that it sucked out of the system through the CRR hike and the partial withdrawal of export refinance to banks, was more than compensated for by the huge devolvements that RBI took upon itself and the securities that it bought through its OMO purchase window.

With roughly Rs. 7,000 crores still lying in the repo with the central bank after the second tranche of measures were kicked in, the central bank had no option but to hike short-term rates through the newly introduced LAF. It hiked its short-term repo ra te to 14-15 per cent to curb speculative pressure on the rupee if any.

The hike in short-term interest rates did not have the desired impact (the rupee continued to depreciate) this time around. The earlier hikes had made liquidity scarce and banks cash-starved. The liquidity panic had led to banks aggressively swapping the ir dollars into rupees, thereby, pushing forward premia to very high levels. High premia levels had, in turn, made it attractive for exporters to sell their dollars in the market.

But this time around, there was no dearth of money (in fact liquidity is better than at normal times). It was just that one had to pay a price for it. In other words, there was no liquidity panic. And, given the huge Government-borrowing programme, every one knows that the repo rate hike is only temporary. This has kept the forward premia levels low, which, in turn, has kept exporters away from the market.

The rupee depreciated a good 120 paise after the hikes, with the central bank doing little to defend it. The RBI finally came into action when it saw the rupee break the crucial psychological level of 46.

Senior officials said they were contemplating asking corporates to convert a part of their EEFC dollars (corporates are allowed to hold a part of their export earnings in foreign currency in an exchange earner's foreign currency account). Later in the da y, the Governor remarked that corporates have also been asked to bring in the dollars raised through GDRs/ADRs. The statements managed to assuage the market (at least for the time being) as the buyers decided to hold their purchases and the rupee closed 25 paise stronger from lows of 46.05.

But, if the central bank does not follow this up with a concrete policy announcement to get the supply of these dollars, I am afraid the relief will only be temporary.

The bond market fell sharply once the rupee started to move in anticipation of a fresh set of monetary measures. But every fall was looked upon as an opportunity to buy, with traders sitting light and the central bank maintaining its placatory stance on interest rates. It actually devolved the 91-day T-bills onto itself at 8.60 per cent when the secondary market was trading at 11 per cent. But, by trying to keep interest rates artificially low, I think the RBI is only postponing the problem.

Of the Rs. 76,000 crores (net) that the Government is scheduled to borrow this year, the RBI has managed to push only Rs. 24,000 crores into the market till now. The one thing that it has had in its favour so far was benign industrial growth. If industri al growth picks up and the US Fed decides to hike interest rates again, RBI will have a problem on its hands. Further pressure on the currency will only make matters worse.

RBI's talking helped the bond market as much as it helped the rupee, and it quickly bounced back to recover most of its recent losses. Going ahead, we could see a temporary rally if the currency stabilises and the central bank slashes the repo rate. But the long-term interest rate outlook continues to be bearish, purely because of the huge supply of Government paper that has to hit the market this year. Inflation worries will also dampen sentiment.

The yield curve has become flat with the market interest stretching only up to six years. Given that we will see heavy issuance in the medium tenor in future, the spreads are clearly unsustainable. One-year govys at 10.70 per cent are clearly attractive with very little downside (as compared to six years at 11.07), as once everything stabilises, it could fall to 10.25. One-year FI paper at 11.90 (you could get that in the primary) is also the best accrual asset to have at this point in time. A portfolio with low duration is recommended.

(The author is Trader, Interest Rates, HSBC. The views expressed here are his own and not necessarily those of his employer.)