Merrill Lynch warns of volatility before stability

Merrill Lynch, in its India Fixed Income Monthly — November 2004 warns of volatility ahead and warns "things could get worse before getting better." The report expects gilts to rule weak in November too despite the sharp rise in yields in October. Factors triggering the weakness, it says, are supply amid tight liquidity conditions coupled with subdued demand from nationalised banks, an uncertain outlook and bearish sentiments.

The repo rate hike and hawkish tone in the policy should keep the market pricing in a higher probability of more rate hikes should conditions deteriorate, notes the report. Adding to the market's woes is the tightening of liquidity. The focus is now shifting to more local issues and easing crude prices and rallying US Treasury bills are likely to have a marginal impact in the short term. The report expects that an improvement in liquidity and buying by banks is the most important factor to watch.

More weakness is in store
Factors triggering the weakness are supply amid tight liquidity conditions coupled with subdued demand from banks. Adding to this will be the uncertain interest rate environment and inflation worries. Global factors might not have as significant an impact in the short run. There could be positives in the form of unwinding of MSS liquidity to support the borrowing programme and other flexibilities depending on market conditions. Liquidity is expected to ease later in November after ruling firm in the first half.

Nationalised banks hold the wildcard, look for increased demand from them before getting comfortable or signs from the RBI that the current round of weakness is overdone and needs to stabilize.

Silver linings
Current levels do discount more rate hikes but tight liquidity and muted buying by banks remain a concern. RBI has indicated that rate rises on supply shocks will be transient and that they will ensure appropriate liquidity. Signs from RBI must be closely monitored to gauge the end of the bearish move.

Strategy
We recommend reducing duration by increasing cash levels. Supplies will likely present opportunities to build positions in short segments. We recommend staying focused on short segments and increasing exposure to auction paper in the short segment as that segment will have likely corrected sharply in the run up to the auction.

Mid-year review of annual policy
As expected, RBI lowered growth forecasts, upped inflation forecasts and highlighted the risks to interest rates if the present unfavorable trends continue. RBI also hiked the repo rate by 25bp keeping other key rates steady. RBI had ahead of the policy given indications of this measured response. Key takeaway was the inflation worry and the need to stabilize inflationary expectations.

A Repo Rate Hike And Tight Liquidity
Gilts weakened in two stages in October. The first stage of weakening peaked with the auction results. Factors worrying the market during this time were higher crude prices, US Treasury bills yields, low demand from banks and also comments from the FM and RBI Governor that were indicative of a rate hike.

WPI inflation largely eased during the month but the final numbers were revised upwards significantly. Gilts got a leg up subsequently buoyed by the overall demand, drop in commodity prices, UST yields, deferment of fuel price hikes and the auction cancellation. This move however fizzled out ahead of the policy announcements as last minute jitters triggered unwinding.

The repo rate hike triggered a sell-off. Comments by RBI officials that the hike was short-term etc failed to support. Finally the state loan announcement triggered losses despite the easing crude and the China rate hike.

Rupee Derivative Segments
OIS moved higher with the weakness in gilts but outperformed gilts. The repo rate hike triggered more weakness in the short end and the OIS curve flattened. Some paying pressure was likely visible as gilts and T-bills yields ruled above OIS levels. MIFOR (Mumbai Implied Forward Offered Rate) rates moved higher with the forward premium. MIFOR swap rates were 25-30bp higher across the curve and the curve flattened marginally.

Credit segments
Bonds weakened in October, the weakness sharpest around the auction of 7.38 per cent 2015. Subsequently, bonds recovered when 5 / 10 gilt spreads started to widen. However, bonds weakened to close around the highest levels after the 25bp repo rate hike. Long bonds weakened in line with gilts and spreads were steady but short segments relatively underperformed as spreads widened sharply. Issuance activity was light with short maturities and floating rate papers being the most popular.

Expectations on INR strength accelerated
The INR / USD exchange rate appreciated over 1 per cent. The triggers came from dollar weakness, rate hikes and easing crude prices. Players started positioning for a stronger rupee early in the month as the dollar witnessed weakness against other major currencies. Visible flows were supportive as equity inflows continued strong. Rate hikes in India and China also had a positive impact as Asian currencies strengthened against the US Dollar. Forward premium ended higher, failing to move lower with the strong INR.