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June 2011

Call money rates traded between 6.85-7.50% in the month on continuing strong demand from banks to meet their reserve requirements. Liquidity in the system was also pressurized after the RBI discontinued the second set of daily LAF auctions as banks were allowed to borrow from the Marginal Standing Facility from May 9. Liquidity in the banking system is expected to tighten further in the coming weeks due to the upcoming corporate advance tax outflows for the April-June quarter by mid-June.

Government bond prices plunged sharply in the month primarily on fears of further monetary tightening by the RBI. The 10-year benchmark paper 7.80% 2021 ended at 8.41% yield on May 31, its highest yield in 32 months and up 28 bps compared with yield of 8.13% on April 29. Market sentiments were battered early in the month due to RBI’s aggressive rate hike to control inflation.  The central bank hiked repo rate and reverse repo rate by a higher than expected 50 bps to 7.25% and 6.25% in its annual monetary policy FY12 on May 3. Continuing high crude oil prices coupled with a hike in price of petrol by Rs 5 per litre on May 14 by the government reignited fears of a rise in inflation and caused worries of aggressive monetary action by the RBI. Prices fell further following higher than estimated April inflation at 8.66% and a surprise growth of 7.3% in India’s industrial output for March as it also raised concerns that RBI may continue with its aggressive monetary tightening actions. The market was also affected after the government revised upwards its borrowing plan through T-bills between May 18 and June 30 by deciding to borrow Rs 75,000 cr in the period from Rs 50,000 cr scheduled earlier. Further fall in prices was however capped on short covering and intermittent positive cues such as sporadic fall in international crude oil prices and weekly food inflation data. Prices also rose later in the month after a Finance Ministry Official told that the government's cash position was comfortable and that it may tweak its weekly borrowing schedule if yields remain high. Sentiments improved further on the last day of the month as inflation concerns eased owing to a lower-than-expected GDP growth reading. Indian economy expanded 7.8% in January-March lower than a revised 8.3% growth rate seen in October-December.

Macro Forecast
Despite robust capital inflows and easing liquidity situation, high inflationary pressures and government borrowings will continue to pressurise the g-sec yield. The lagged impact of policy rate actions have started reflecting in the macro environment as evidenced by the slack in investment and the GDP growth moderation. We expect that that the additional anticipated policy hikes  of 50-75 bps would be based on incremental data points on inflation and the overall growth environment and could be spaced out over the coming months.