Recent Debt Market Events

U.S. economic conditions have continued to worsen with the housing market showing no signs of finding a bottom, credit turmoil still rampant and a continuous wave of defaults from financial entities. This has caused a sharp fall in the value of the USD against the other currencies. Commodity prices have increased sharply on account of good demand from funds and a decline in the USD value. Oil and Gold prices, in particular, have been hitting record highs. Against this backdrop, domestic market conditions have also been impacted. There has been continuous selling pressure from the FIIs in the stock market and they have pulled out around USD
3.24 bn (around Rs 13,200 Crores) year to date (till 14th March 2008). (Source: LIAMC research; Bloomberg). Ballooning trade deficit on account of high oil import bill coupled with FII outflows have resulted in dollar shortage and consequent dollar appreciation against the rupee. This also has negative implications for imported inflation from the supply side. The government as well as RBI have been concerned on this account and have indicated that inflation would remain at the top of their fiscal and monetary policy agenda, respectively. Indeed, the recent inflation numbers have surprised on the upside and have postponed rate cut expectations from the RBI. On the flip side, Index of Industrial Production (IIP) numbers have surprised on the downside with January 08 y-o-y growth at 5.3% against expectations of around 8% (Source: Bloomberg, LIAMC research). The worrying part was a sharp decline in capital goods growth to a meager 2.1% (the lowest monthly y-o-y growth since 1994) leading to fears that investment spending might be slowing down. Consumption spending is already showing signs of a slowdown as evidenced by a decline in consumer durables (-3.1% in January 08) during FY08. Given this scenario, we believe that the Central Bank is likely to keep policy rates unchanged in the near term while it analyzes incoming data on economic growth. We expect growth concerns to take prominence over inflation fears in the coming months as global economic growth slows, led by the United States. The other key factor to take note of is the Chinese economy which has grown at a blistering pace in the last few years. The Chinese monetary authorities have been trying to moderate economic growth and rising inflationary pressures by following a continued tightening in interest rates and increasing the level of cash reserves in the Banking system. Lagged impact of tighter interest rates and the fact that this being the year of the Olympics, Chinese economic growth is likely to slow, going forward. This coupled with slower growth elsewhere in the world could have a salutary impact on commodity prices, going forward.
Coming to the debt market, yields at the short end inched up towards Feb end as systemic liquidity tightened on outflows towards MSS auctions, state loan auctions and increasing government balances with the RBI. Yields were also carrying a “March premium” as the market was expecting tighter liquidity conditions in March. However, liquidity conditions have remained normal in March so far due to government spending and the fact that market participants have been maintaining liquidity on expectations of tightness. Additional Liquidity Adjustment Facilities (LAF) Auctions by the RBI on 14th March and 17th March 2008 have been conducted in order to manage liquidity conditions. Consequently there has been a downward movement in yields at the short end with the 1 year prime rated Certificates of Deposits’ yield correcting by 25-30 bps compared to end February levels. However, yields in the 1-2 year segment continue to be higher due to continuous supply from issuers.