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July 2012

Call money rates hovered between 7.75% and 8.25% during the month, with the higher range primarily due to surge in demand for funds in the reporting fortnights. Increased borrowing by banks to meet reserve needs for four days ahead the Reserve Bank of India’s (RBI’s) annual closing of accounts on July 2 also pulled up the rates in the latter part of the month. The rise in rates was, however, restricted by comfortable liquidity situation in the banking system for most of the month.

Gilt prices rose in June amid high volatility. The yield on the benchmark 10-year 8.79%, 2021 fell to 8.38% on June 29 from 8.42% on May 31. Prices were primarily supported by hopes that the RBI would cut the key policy rates in its mid-quarter review of its monetary policy due to a slowdown in domestic economic growth and weak industrial production amid a weakening global economy. Intermittent buyback of gilts by the central bank through open market operations (OMOs) in the month and the RBI’s statement that it will continue with the OMOs to infuse liquidity as and when required also helped gilt prices in the month. Bond prices also gained as talk of RBI intervention in the forex market led to expectation that the RBI may conduct more bond purchase auctions to counterbalance the liquidity drain caused by its dollar sales. Weak risk appetite globally due to negative cues from the US and eurozone also augured well for the bonds. The government’s announcement that it will issue a new 10-year paper also had a positive effect on bonds as the issuance of a new 10-year gilt usually pulls down yields across tenures. Meanwhile, the yield on the new 10-year 8.15%, 2022 bond ended at 8.18% on June 29 as compared to 8.16% on June 8.

Gains in gilt prices were reduced after the RBI, against the widespread expectation of slashing interest rates, retained key policy rates giving priority to inflation over growth. Sentiments were further dampened after Fitch Ratings cut India's outlook to negative and S&P's Ratings Services warned that India faces the risk of losing its investment-grade rating. Markets also reacted negatively after the RBI hiked the FII investment limit for gilts by $5 bn to $20 bn as the additional investment has been allowed only in securities with a residual maturity of three years. Demand for safe haven bonds fell as a positive outcome from the European Union (EU) summit increased global risk appetite.   

Macro Forecast
We expect the yield on benchmark 10 year G-sec to settle around 8.0-8.2% by March-end 2013, higher than their earlier expectation of 7.5-7.8% due to a higher fiscal deficit. We expect upto a 100 basis points (bps) cut in the repo rate (which forms the floor of the 10-year G-sec yield) by Reserve Bank of India (RBI) in the rest of the fiscal to support growth, downside to 10-year G-sec yield is limited, given the size of the government borrowings.