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Pranav Thakur

THE market has seen a complete reversal of sentiment over the last month. Till about a month back, it refused to fall on any negative news. Even an Rs 11,000 crore OMO supply from the central bank got absorbed without any appreciable rise in yields. It looked like interest rates could only go down. And quite rightfully, nobody wanted to miss the ride. Hence any bad news would see scanty selling and vicious buying.

The sentiment seems to have soured quite significantly in the recent days. Traders do not want to touch anything that comes close to a bond under any circumstance. The ten-year sovereign yield has climbed up by a good eighty basis points from its lows.

The corporate bond market is in a shambles with close to zero liquidity. All the buyers who showed unprecedented muscles earlier seem to have gone into hibernation. It might be worthwhile to look at what has changed so dramatically over the last month.

In retrospect, everyone says that in the first place it was foolish for the market to have taken the ten-year yield to 7.85 per cent, when the repo rate was 5.50 per cent. But what had happened was that the market was pricing in a repo rate cut over the next two months and quite rightfully so.

Dr Jalan had made it very clear in his October monetary policy that he would not tinker with the bank rate this financial year. However, he had chosen to remain silent about the repo rate. Moreover, whenever he was asked about an impending repo rate cut, he would always say `not now, not today, not this week'.

I would interpret these remarks as signifying a cut in the future. So the market's expectation of one was not altogether misplaced. The surge in dollar inflows further augmented the case for a reduction in the interest rate differential, hence a repo rate cut.

The market participants, however, misjudged the inherent strength of the market. Everyone thought that the market was so strong that it just could not fall between then and the actual repo rate cut. Hence all the traders decided that there was little downside and a possible large upside in positioning themselves for a repo rate cut that was months away.

Little or no primary supply of Government bonds in the months of January and February added credence to these expectations. The traders as well as the investors were sitting mega long when the RBI hit the market with an Rs 11,000 crore OMO supply. Everyone was already sitting so long that the market just crumbled under the weight of the OMO supply and fears of a war in the Gulf.

It looked like the market was showing signs of stabilising when the RBI announced Rs 14,000 crore of bond issuance by the States this fiscal to enable them to prepay the expensive debt of the Central Government. This State Government borrowing is essentially a substitution of the Central Government's borrowing as the States are using this money to pay the Centre. It is just that the supply of bonds has effectively been preponed.

The Central Government was anyway not looking to borrow this year, so this money only will reduce the Centre's borrowings for the next year. This fresh supply in an already fragile environment has further weakened sentiment and appetite for bonds. A jump in the WPI index in the last month has also not exactly been a comfort provider in these bad times.

People have lost so much money in the last month that their risk appetite has reduced very significantly. I know for sure that the traders hardly have any worthwhile positions at this point in time, but they are still reluctant to buy. Investors are yet to meet their year-end profit targets; hence we continue to see some AFS (available for sale) selling and very scanty buying from them. The uncertainty on account of what the Finance Minister is going to do to the small savings rate in the forthcoming Budget makes the market further risk averse.

There might be some more pain left in the market if Mr Jaswant Singh decides to leave the small saving rate unchanged (given 2004 is the election year). The RBI also might want to wait to see how the war situation plays itself out before deciding on any rate cuts. It might even want to wait for a few more weeks to see how the inflation data fare. So in these circumstances, one might see the ten-year yield even touch seven per cent. But somehow I have a feeling that the repo rate cut might be sooner than later.

You might actually see some positive surprises in the Budget as well. A lower actual fiscal deficit for 2002-03 and a smaller than expected number for 2003-04 could provide a positive fillip. A fifty basis points cut in the small savings and the RBI relief bond rates could pave the way for the central bank to cut the repo rate sooner than the market expects at this point in time. Even the headline inflation number should start dropping from mid March on account of the base effect.

(The author is senior trader, Interest Rates at HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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