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Fixed income markets saw interest rates spike up sharply this week. In view of sustained weakness and volatility in the rupee in past couple of months following first indications by Fed of tapering in late May and the subsequent sell-off in global currency and bond markets and deteriorating global investor sentiment towards India, Reserve Bank of India (RBI), last Monday, unexpectedly tightened interest rates through indirect measures. It capped lending to banks under liquidity adjustment facility at regular rate of 7.25% (repo rate) to Rs 75,000 crore, hiked the rate at which it would lend over that amount by 200 bps to 10.25% and announced an open market sale of bonds.
Market participants who were still reconciling to diluted expectation of no rate cuts but were still confident of no tightening measures at this stage, on the basis of supportive domestic factors like moderating inflation, dismal growth and government’s strong resolve to contain fiscal deficit were completely taken aback by this development. In a knee-jerk reaction, fixed income markets sold off with short term rates shooting by over 250 bps and bond yields surging by 50 bps the following day. Suddenly there was a sense of a complete freeze and catastrophe in the markets. The benchmark 10-year government bond yield hit a high of 8.10% in intra-week trading, compared to last week's closing of 7.55%. The three-month bank certificate of deposit rates hit a high of 10.50%.
Subsequently, finance ministry officials issued a series of statements indicating that these were temporary measures and could be reversed as and when the rupee stabilses. The government also cancelled the scheduled treasury bill auctions for the week and only partially accepted bids in the weekly government bond auction. RBI also opened a special liquidity facility for mutual funds. These measures and the sharp correction which took place in the previous sessions led to some bargain hunting helping the markets recover some of the early losses.
The economic environment remains challenging with persistent concerns on lack of visibility on dollar inflows. While a series of measures including restrictions on gold imports, hike in FDI limit in several sectors and hike in petroleum product prices have been taken, a hesitant RBI was forced to resort to these tightening measures. While optimism remains that these measures will be transient, ground reality is that of a tightening cycle in spite of the obvious reluctance. Having corrected sharply, bond prices may recover somewhat in the coming week. However, markets are now quite apprehensive and are likely to see profit booking on further rallies. The next monetary policy review is due at the end of this month, and traders will watch for fresh guidance from RBI before any decisive action.
Mahendra Jajoo is Executive Director & CIO-Fixed Income at Pramerica Asset Managers
