Bond yields ease as inflation rate falls to a 26-month low

Rate cut hopes spread, with guessing on when RBI might do it and by how much

Yields on government bonds eased on Tuesday as a fall in headline inflation to a 26-month low in January raised hopes for an interest rate cut by the central bank in its March policy. Yields on the 10-year benchmark government bond eased two basis points to close at 8.18 per cent.

Wholesale Price Index-based inflation fell to 6.5 per cent, within the Reserve Bank of India’s projected trajectory of seven per cent inflation by March end. Importantly, the non-food manufacturing inflation rate, proxy for RBI’s core inflation, has slowed significantly. In addition, the third quarter GDP growth figures to be released by the month end are expected to be weak, making a stronger case for the central bank to reduce interest rates.

“Today’s inflation data, coupled with a likely weak GDP growth out-turn for October-December increases the chance of a policy rate cut in the March 15 policy review,” said economists Taimur Baig and Kaushik Das of Deutsche Bank. Non-food manufacturing inflation fell to 6.7 per cent in January after averaging eight per cent during the October–December quarter.

Market participants see further softening of bond yields, as the government is expected to announce a smaller fiscal deficit target for the next financial year. “While the benchmark yield could trade in the 8-8.15 per cent range in the near term, the prospect of policy rates easing in April, along with easing inflation and a smaller fiscal deficit target for FY13, could drive the yield below eight per cent by the beginning of April,” said Abheek Barua, economist at HDFC Bank.

The lender expects the government to announce a fiscal deficit target of 5-5.2 per cent of GDP against the actual fiscal gap of 5.6-6 per cent of GDP in the current financial year.

“The yield curve could retain its flattening bias till March-end but is expected to steepen going into the next financial year, with repo rate cuts gathering momentum,” Barua added.

After increasing interest rates 13 times between March 2010 and October 2011, the central bank then took a pause, not raising the rate in consecutive policy meetings, as growth concerns intensified.

RBI also reduced the Cash Reserve Ratio in the January policy to give a boost to growth, without sacrificing the anti-inflationary stance.

The central bank will announce its mid-quarter review on March 15, a day ahead of the Union budget for 2012-13.

Since RBI had clearly said the country’s fiscal position would be among the factors shaping the stance of the monetary policy, a section of economists said it might wait till the April policy for the rate cut as the budget, which will indicate the fiscal position, is to be announced a day after the mid-quarter review in March.

“The probability of a repo rate cut in March has risen, in our view, though our base case still calls for cuts from April, as RBI wants to see fiscal consolidation in the budget. We expect 100 basis points of repo rate cuts this year,” said Sonal Verma, chief economist, Nomura Securities.

Even if the rate cut is postponed to the April policy, the central bank may yet again cut CRR to help banks tide over the liquidity crunch. Despite the CRR cut from the last week of January, banks borrowed more than Rs 1 lakh crore daily from the repo window. Today, banks borrowed Rs 1.7 lakh crore from the window, a six-week high.