RBI acknowledges moderation in growth, hints at a cease in rate hikes.

Hikes key interest rates by 25 bps, in line with market expectations.

In the second quarter monetary policy review on 25th October 2011, RBI raised the key interest rates by 25 basis points - Repo at 8.5% and Reverse Repo at 7.5%. The Marginal Standing Facility (MSF) rate, determined with a spread of 100 basis points above the repo rate, stands at 9.5%. This is the 13th consecutive rate hike implemented by RBI. The Indian central bank has been very aggressive in tackling inflationary pressure even as other economies are now beginning to opt for a pro-growth monetary policy stance.

Policy highlights GDP growth projection for 2011-12 revised downward to 7.6% from 8%. WPI Inflation forecast for March 2012 unchanged at 7% Repo rate hiked by 25 bps to stand at 8.5% Reverse Repo rate up by 25 bps to 7.5% CRR unchanged at 6% Non-food credit growth projection maintained at 18%. M3 growth projection retained at 15.5%. Fiscal deficit to exceed targeted levels.

Monetary stance of RBI Rate hikes implemented by RBI may not have been able to bring inflation down to targeted levels. Nevertheless, they have been instrumental in containing inflationary expectations. RBIs policy stance is intended at

Maintaining an interest rate environment to contain inflation and anchor inflation expectations. Stimulating investment activity to support raising the trend growth. Managing liquidity to ensure that it remains in moderate deficit, consistent with effective monetary transmission.

Guidance: RBI identifies slackening investment activity beside inflation as the factor contributing to the slowdown in GDP growth. RBI expects the inflation rate to ease by mid-December. Less likelihood of another rate hike in its December Monetary policy review if inflation trend is in line with projected numbers.

There has been a 375 bps rate hike in the Repo rate, brought about by RBI since March 2010 till date as a tool to contain inflation. But the response of headline inflation index to this series of rate hikes has been quite lukewarm.
10.00 % 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00
Interest rates

Key Interest rate movements in the economy March 2004-Oct 2011 375 bps

Mar-04

Jul-04

Apr-05

Aug-05

Apr-06

Aug-06

Apr-07

Aug-07

Apr-08

Aug-08

Apr-09

Aug-09

Apr-10

Aug-10

Apr-11

Reverse Repo

Repo

CRR

Aug-11

Dec-04

Dec-05

Dec-06

Dec-07

Dec-08

Dec-09

Dec-10

Interest rate versus Inflation We plotted inflation components against repo rate trend between 2008 and 2011. Repo rate (Black line - below) shows a sharp upward trend between May and Sep 2011, while growth in headline WPI inflation (orange line) is seen moderating during the same period. Major contributor to inflation as seen in the graph above is Primary Article index, followed by Fuel index. Components of Inflation index Inflation and Interest rate trend Jan 2008-Sep 2011 Repo rate (%)
10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Jul-08 Sep-08 Nov-08 Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Repo rate

220 200 180 160 140 120 100

Jan-08

Mar-08

Headline inflation trend

May-08

Primary Articles

Manufactured products

Fuel

Source: RBI, Future Capital Private Wealth Research

But the growth trend in these components reveals a different picture. While moderation is seen in Primary article index growth, fuel index has posted a continuous upward trend in the past four months.

Uphill task for RBI While interest rates have been raised more than a dozen times in the past 20 months, inflation is still sticky at higher levels. The Indian economic growth has given out sufficient signals of a slowdown as also reflected in the tempered growth expectations by RBI. Given this situation, the effectiveness of monetary tightening depends upon the happening of following events: Moderation in the global demand for commodities which could in turn soften their prices and thus lower domestic inflation Pick up in the investment cycle leading to industrial growth. The investment demand currently reels under the impact of elevated interest rate regime.

RBI expects the current high inflation trend to persist for the next two months going till December. Once the interest rates begin to peak, we can reasonably expect the government bond yield curve to gradually turn upward sloping. The short end of the yield curve (up to 3 yr maturity) is likely to benefit from this yield curve shift. Read on to know the best way to tap this opportunity.

High interest rates and Rising bond yields an opportunity to tap!

In the past couple of weeks, the Indian GSEC 10 benchmark bond yield has sky 10-yr sky-rocketed to 8.8% levels from being in the range of 8.2 8.3%. This can be attributed to increased supply of bond 8.2-8.3%. issuances in this maturity range as the Indian government announced hikes in its H2FY12 borrowings. While market expects further rise in the yields of longer dated paper, investors can look wings. at more interesting opportunities that the fixed income market offers.

Stagnating yields in the short end of the yield curve The Certificate of Deposit (CD) rates for 3 and 6 months rose since April 2010 in tandem with the repo rate hikes implemented between Apr 2010 and March 2011. From thereon, the Repo has risen 150 bps till Oct 2011. But the CD rates have stagnated between 9 9.25-9.4% during this period. 9.4% This indicates the relative resilience of short duration instruments to rate hikes. This makes an interesting case for investors to move further up the yield curve and look at higher duration.

Bank CD rate (%) 11.5 10.5 9.5 8.5 7.5 6.5 5.5 4.5 3.5

Rate Hikes and Bank CD rate movements Dec 09-Oct 2011 Repo Rate (%)
9 8.5 8 7.5 7 6.5 6 5.5 5 4.5 4 Apr-10 May-10 Apr-11 May-11 Jan-10 Mar-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

Dec-09

CD 3 MONTHS

CD 6 MONTHS

Repo

h Source: RBI, FCH Private Wealth Research

Systemic Liquidity deficit - another cause for short term rates spiking The systemic liquidity as indicated by the difference between reverse repo and repo bids shows a deficit from July 2010 onwards till date. The (daily) average liquidity deficit in the system for this year (2011) stands at negative Rs. 57000 Cr. This is much worse as compared to (daily average) negative Rs. 10900 cr in 2010. Surplus/ Deficit Liquidity in the system and Interest rates Corridor 2010-11
9

Interest rates (%)

8 7 6 5 4

Net Liquidity in the system (Rs. Cr)

80000

30000

-20000

-70000 3 2 4-Jan-10 4-Feb-10 4-Mar-10 4-Apr-10 4-May-10 4-Jun-10 4-Jul-10 4-Sep-10 4-Oct-10 4-Nov-10 4-Dec-10 4-Jan-11 4-Feb-11 4-Mar-11 4-Apr-11 4-May-11 4-Jun-11 4-Jul-11 4-Sep-11 4-Aug-10 4-Aug-11 4-Oct-11 Repo Rate -120000

Liquidity surplus/deficit Source: RBI, FCH Private Wealth Research

Rev repo rate

Liquidity deficit coupled with further proposed market borrowing for H2FY12 by the government (in order to stem the widening fiscal deficit) will put pressure on the liquidity in this financial year. Inverting of the Government bond yield curve what to expect?
9 8.9 8.8 8.7 8.6 8.5 8.4 8.3 8.2 8.1 8 3M 6M 1Y 2Y 3Y

Indian GSec Bond yield curve

Oct 11 Sep 11

Bond Yield

4Y

5Y

6Y

7Y

8Y

9Y

10Y 11Y 12Y 13Y 14Y 15Y 19Y 24Y 30Y

Maturities

Source: Reuters India, FCH Private Wealth Research

Indian government bond yield curve in October is inverted and more pronounced than that seen in the previous month. The inverting implying that longer dated instruments have a lower yield than short term instruments.

The spike in short end of the yield curve in October has been caused by tight liquidity conditions [see Liquidity deficit graph above]. Given the rigid rates of the short term instruments, the upside gain for these instruments arising from future rate hikes is capped. The lowest points in the yield curve for September and October are the 2 and 3 year instrument yields. From trading at 8.22% in the previous month, this 3 yr yield has further hardened to 8.41% implying cheap valuations. Why not long duration bonds? The government bond issuances for the second half of FY12 will have a larger portion allocated towards longer term maturities between 10-19 years. Increased borrowing comes on the heels of widening fiscal deficit as rise in crude prices, depreciating rupee and lower tax mop up. This is likely to cause the yields in this region to rise gradually implying fall in the prices of these bonds. The risks associated with investing in longer term papers remain elevated as compared to those in the medium-to-shorter term papers. How do we play the yield curve? Investors can benefit from the expected yield curve movement by increasing duration of their fixed income portfolio to 2-3 years going up to a maximum of 5 years. To increase duration in your portfolio you need to Why dynamic bond funds? This category of short term / income funds follows a flexible approach and effectively plays the curve by moving into the most lucrative duration zone on the curve. The dynamic nature of these short term funds ensures that the investors benefit from any kind of yield curve movements.

Income and Short term plans Birla Sun Life Dynamic Bond Retl Gr DSP BlackRock Strategic Bd Reg Gr HDFC High Interest S/T Gr Reliance Regular Savings - Debt Gr HSBC Flex Debt Retl Gr DSP BlackRock S/T Gr Templeton India Income Opp Gr DWS Short Maturity Gr Birla Sun Life M/T Retl Gr
th

Fund size (Rs cr)

Avg Eff Maturity (Yrs) 4.30 2.22 1.83 1.52 1.37 1.22 1.00 1.00 0.78

Avg Modified Duration (Yrs) 2.92 1.58 1.45 1.52 1.06 1.02 0.70 0.86 0.51

1 mt Returns (%) 0.26 0.39 0.46 0.52 0.44 0.59 0.70 0.57 0.63

3 mth Returns (%) 1.76 1.87 1.79 1.99 1.75 1.97 2.19 2.20 2.05

6 mth Returns (%) 4.46 4.22 4.21 4.20 4.34 4.43 4.70 4.57 4.67

1 yr Returns (%) 7.86 7.39 7.01 7.28 7.89 8.20 7.93 7.88 8.93

2347.44 661.53 1138.60 1031.00 74.91 686.32 4054.78 575.34 947.64

Performance Data as on 24 Oct 2011 Absolute returns up to 1yr. CAGR above 1 yr Source: Morning Star

Disclaimer: The information, figures, graphs, charts, analysis and conclusions contained herein are for information purposes only. Historical and current price performance data is not necessarily indicative of future performance. The information provided there in is only indicative and is without warranty of any kind and, in particular, no representation or warranty, expressed or implied is made nor should any be inferred as to the accuracy, timeliness or completeness, of any such information. The Client(s) understand and agree that it must obtain an independent advice, and will not rely on the information provided by Future Capital Holdings Ltd. (Future Capital). Under no circumstances shall Future Capital, have any liability to any person or entity for any direct, indirect, special, consequential or incidental loss, damages whatsoever resulting from the use of, or inability to use, any such information. Future Capital is not responsible for any errors in data reproduction. Future Capital especially states that it has no financial liability whatsoever to the subscribers/ users/ transmitters/ distributors of the information/ bulletin. No investment information shall be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. There can be no assurance or guarantee that any investment will achieve any particular return. Past performance of investments is no guide to future performance. The Client(s) may not get back the amount of capital that the Client(s) invest. Any income projections and yields are estimated and are included for indication only. Future Capital may enter into and receive the benefit of generic commission, discount and rebate arrangements from product issuers, providers and other transaction counterparties. Future Capital reserves the right to retain any such amount, received without any obligation to disclose or pass such benefits to Client(s).