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May 2011

Inter-bank call money rate moved in the broad range of 5.75-6.90% mainly due to strong demand from banks to meet their reserve requirements, especially in the later part of the month. Rates were also pressurized in the latter half of the month as banks borrowed more on fears of a possible rate hike by the RBI in its credit policy on May 3. These fears came true after the central bank hiked repo and reverse repo by 50 bps to 7.25% and 6.25% respectively. Further, the RBI also decided to transit to single independent varying policy rate and that will be the Repo rate while the reverse repo rate will continue to be operative but it will be pegged at a fixed 100 bps below the repo rate. The weighted average overnight call money rate will be the operating target of monetary policy of the Reserve Bank. The central bank also introduced a new mechanism, Marginal Standing Facility, under which banks would be permitted to borrow short term funds up to 1% of their deposits at 8.25% i.e. 100 bps above the repo rate. Meanwhile, call rates did not rise sharply in April due to improved liquidity situation in the financial system. The rates got further support after RBI informed that it will continue to conduct the second set of auctions under Liquidity Adjustment Facility or LAF until May 6 (which was supposed to end on April 8) and will also not penalize banks for a shortfall of up to 1.0% of SLR requirement arising after availing this facility.

Gilt prices ended lower during the month, with the new 10 year benchmark paper 7.80% 2021 ending at 8.13% yield on April 29, as compared to 7.89% on April 11, when the new paper was introduced. The erstwhile benchmark paper 7.80% 2020 ended at 7.99% yield on April 8, as against 7.98% on March 31. Prices were down earlier on view that demand for the new 10-year paper will be weak due to lower-than-expected coupon set on the new bond. Sentiments worsened as fears mounted regarding aggressive interest rate hike following an unexpectedly high inflation rate of 8.98% in March as against the RBI's March-end projection of 8.00% and compared with inflation of 8.31% in February. Sentiments for gilts were also dented on expectations of another fuel price hike, and the resulting inflationary pressure triggering action from the RBI. Some losses got however capped on intermittent short covering.

Macro Forecast

Despite robust capital inflows and easing liquidity situation, high inflationary pressures and government borrowings will continue to pressurise the g-sec yield. Given the stance of central bank and a large government borrowing program, bond yields are likely to have an upside bias in the near term. We expect that the liquidity situation would start tightening going forward driven by monetary tightening, higher supply of T- bills and Cash management bills and the scheduled G sec auctions.