Special Report
Despite the steep fall in domestic interest rates, Indian debt markets look more attractive than most other developed and emerging markets
Interest rates have been heading south in most parts of the world and looking at factors like inflation, economic data and the geopolitical situation, they are poised to slip further.
Let's start with the biggest of them all, the US markets, which dominate on sheer size. They have also seen the most substantial interest rate cuts to date.
Since the beginning of 2001, the Federal Reserve has cut its Fed funds target rate 11 times, bringing it down from 6.5 per cent to 1.25 per cent. Of late there was a change in perspective and the Fed maintained a neutral stance.
However, less than encouraging post-war inflation, unhealthy employment and GDP growth numbers have left their impact on the economy.
US government figures showed the unemployment rate rising to six per cent in April as businesses cut thousands of jobs for the third straight month, extending the worst stretch for labour market since World War II.
The Labour Department said its Consumer Price Index, the government's main inflation gauge, rose 0.3 per cent after rising 0.6 per cent in February, while the core CPI, which excludes the often volatile food and energy prices, was flat after rising 0.1 per cent in February. Economists, on an average expected the CPI to rise 0.4 per cent and core CPI to rise 0.2 per cent.
Tuesday's Federal Open Market Committee meeting, where the Fed openly expressed worries about the economy entering a deflationary environment, saw a huge drop in treasury yields. "There is a lot of deflation talk that is stalking US markets," says Milind Nandurkar, debt fund manager at Sun F&C Mutual Fund.
"The US securities markets is in a bullish mode in what is called 'deflation trades'. The consensus is that if the economic data is as depressing, there is a high likelihood of a 25 basis point rate cut in the near future," he adds.
Not everybody agrees. There is another section which feels a rate cut in the near future appears improbable. "In our view, the US is not really comfortable with the present low levels of interest rates and we do not foresee a further cut soon," says Kishlaya Pathak, economist, Standard Chartered. He feels that interest rates will, in fact, rise to around 2.5-3 per cent in a year's time.
In European markets, the European Central Bank has kept its benchmark rate at 2.5 per cent last Thursday, double the Federal Reserve's rate, which was left unchanged on Tuesday as the Fed switched its policy bias to weakness, raising the chances of a cut.
The euro rose 2.5 per cent versus the dollar last week, its biggest gain in more than 10 months, as comments from ECB president, Wim Duisenberg, prompted speculation that policy makers may not cut interest rates soon. The rate on the Euribor interest rates futures contract for June held at 2.36 per cent, suggesting investors aren't convinced about the prospects of a cut by then.
"The ECB has been more restrained in cutting rates," says Nandurkar. "After a common currency, European countries have a committee approach in reaching an agreement to contain fiscal deficits. Inflation levels are on the higher side.
However, there are issues like the budget deficit. The deficits of some member countries are higher than the prescribed levels. It is very likely that the ECB is likely to cut rates by 25-50 basis points in June," he adds.
Nandurkar says that UK has one of the highest interest rates. The economy there has benefited from higher property prices and mortgage rates which have been buoyant for the last two years.
However, he says, although the Bank of England has left rates unchanged for now, the weakness is making its presence felt and property prices are beginning to soften.
Among Asian markets, Japanese interest rates have been near zero and they are fighting deflation. The yen had risen almost 10 per cent against the dollar in the past 12 months, reaching a 10-month high last week. However, marketmen feel that investors are reluctant to buy the yen because of the Bank of Japan's record of selling the currency to protect the country's exporters.
Incidentally, Japanese exports account for 11 per cent of the national income. The Japanese finance minister has also recently indicated that the nation may sell the currency again soon. Amitabh Mohanti, fund manager at Alliance Capital feels that Japan will focus on liquidity management as the prevailing low rates make it difficult to go in for further rate cuts.
Then again, investing in bonds of emerging markets have proven to be a surprisingly safe haven in recent months as US stocks have moved up and down and money market yields have dropped below one per cent.
However, there are reservations that the fortunes of emerging markets can change quickly along with the political situations in regions such as Latin America and parts of the Pacific Rim.
Indeed, emerging-market bond funds returned 12.5 per cent this year and 11.2 per cent in 2002, according to Chicago-based Morningstar Inc. That surpasses returns for the average taxable bond fund (2.9 per cent gain this year; 6.3 per cent last year) and domestic stock fund which gained 3.2 per cent this year compared to a loss of 20.8 per cent in 2002. According to AMG Data Services, based in Arcata,
Calif, investors are known to have poured $581 million into emerging-market bond funds in the first quarter 2003, more than the $538 million invested in CY 2002. Through mid-April, inflows came to $649 million.
India has seen steep interest rate cuts in the recent past, with most of them taking place in the last five years. Opinion is divided on the issue of further cuts. "Domestic interest rates are near the bottom," says Kishlaya Pathak.
Two important factors, like headline inflation numbers and liquidity scenario, will have a bearing on rates. The yield on benchmark 10-year government bond will be hovering around the 5.75-6.25 levels and they would fall below that if any adverse news from the monsoons trickle in, he adds.
Nilesh Shah, director and chief investment officer of Franklin Templeton Investments feels the search for liquidity has led investors to emerging markets. "India offers high liquidity with foreign exchange inflows peaking. The interest rates are almost at an all-time low.
Oil prices, along with the effect of the transporters strike, would push up inflation. Inflation would come to the fore and drive interest rates from now on. However, a repo rate cut is on the horizon," he adds.
On the other hand, Mohanti feels that rising forex reserves are adding to the liquidity in markets, which could exert a downward pressure on rates. "The present conditions support a cut and one should keep a close watch on the Indian economy," he adds.
Currency wise, the euro reigns supreme. The rupee is rising against the dollar, but marketmen feel that its weakness against other currencies would negate any adverse impact it may have on interest rates. The South African rand, and Canadian and Australian dollars are expected to head higher.
Among world markets, the European markets are looking pretty well poised. Marketmen feel that the three factors of a strong currency, interest rate carry and expectations of a higher rate cut bode well for European markets.
Nilesh Shah of Templeton feels that looking at currency adjusted returns expectations of market attractiveness, India looks pretty appealing. The double advantage of a strong currency and high rate of return should work in its favour, he adds.
