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February 2011

Interbank rates traded in between 6.25%-7.0% during January

Interbank rates traded in between 6.25%-7.0% during January. Earlier, the rates were stable as liquidity improved in the banking system due to government spending and bond purchases by the RBI through open market operations (OMOs). To ensure adequate liquidity in the system, the RBI, in its policy review on January 25, extended daily second Liquidity Adjustment Facility (LAF) tender till April 8 and also allowed leeway of 1% of SLR till that time, from the earlier date of January 28. It also said that RBI would prefer to maintain the LAF corridor at 100 bps unless there is a "new perspective". RBI has also highlighted the growing mismatch between credit and deposit growth and increased the fiscal year end inflation estimate from 5.5% to 7% with an upward bias.

Government bond yields rose sharply in January with the 10-year benchmark 7.80% 2020 paper’s yield closing at 8.14% on January 31 as compared to 7.91% on December 31. Fears of monetary tightening by the RBI on the back of high inflation primarily led to the rise in yields. Monthly WPI inflation for December rose to 8.43% compared with 7.48% in November. Hike in petrol prices (on January 15) further added to rate hike fears and pushed the 2020 paper’s yield to a 27-month high level of 8.23% on January 17. Selling pressure was also witnessed in the benchmark paper on view that paper may become illiquid as its outstanding approached near Rs 60,000 cr, an informal limit for any single security.


Further rise in yields for bonds were capped as sentiments improved due to the RBI's non-aggressive rate action at its third-quarter policy review. Yields also fell on intermittent short covering and improved liquidity situation in the system. The 10 year benchmark paper was also able to overcome illiquidity fears on purchase of the paper by the RBI through OMOs and expectation that it may remain the benchmark for the rest of this fiscal year.

Macro Forecast

RBI has rightly mentioned that sustaining credit growth over 20% would be tough given the mismatch in liquidity conditions. RBI is likely to raise policy rates by another 75 bps over the next couple of months as inflation is unlikely to soften. The next critical event to watch would be Union budget as a high fiscal deficit along with tight monetary policy could seriously impact the growth prospects in FY 12 and beyond. Bond yields are likely to remain range-bound and will resume the upward trend post the announcement of Union Budget. Money market rates would be driven by systemic liquidity and demand-supply factors. Though liquidity conditions could improve a bit as government spends (currently sitting on a surplus of Rs. 1.13 lakh crores) over the next 2 months, rates are likely to remain elevated due to constant supply from banks. On the positive side, we believe that deposit growth would continue to inch up given the substantial rise in deposit rates and would ease the pressure on systemic liquidity over a period of time.