Primary Auctions, OMOs Push Yields Higher…

The headline WPI inflation for April 22 came in at 15.10%, and it is the highest reading so far indicating the likelihood of more inflation being priced in the future retail inflation numbers. The persistently high oil prices in global markets and the weak Rupee will exert pressure on the domestic price level which has already deteriorated far beyond the threshold set by the RBI.
The amelioration of these inflationary pressures is important not only from the perspective of preserving growth but also from the point of view of protecting consumption demand. In the interim policy announcement RBI hiked the repo rate and CRR, and in the ensuing policy meet it is expected that there may be further hike. Apart from combatting inflation, the depreciation of the currency can be arrested to some extent through rate action. This assumes greater significance as the trade deficit is worsening and the outflows on account of overseas selling is continuing unabated. These factors point towards more policy tightening.

The other major factor is the government borrowing program and the borrowing completed so far stands close to 15 % of the overall borrowing program. While this program is so far not supported by any liquidity support from the RBI, the impact of the borrowing on rates especially the rates at the long end cannot be ruled out. While the 10-year benchmark is trading at 7.37 %, the cut offs at the latest SDL auctions were at 7.70 % for the 10 year, 5-year at 7.46 % and 8-year at 7.63 %. The spread against the 10-year GOI paper is barely 34 basis points, and this may widen closer to historical averages. Given the expected issue or supply of long dated papers at the primary auction, the yields may have more upside. On the 10-year benchmark, 7.60% and 7.80 % stated in the earlier updates are still valid, and only on saturation of this up-move or somewhere close to that should investments be initiated at the long end. It may be mentioned here that the OMO sale by the RBI also disturbed the markets though not significantly.

While the overnight rate has moved up to 4.00 %, the last variable rate reverse repo auction had a weighted average cut off of 4.38%, almost 50 basis points higher than the levels prevailing before the rate action. The latest balance in the Standing Deposit Facility is Rs. 2.25 Lakh Crs approximately, and the systemic liquidity is at Rs. 4.88 Lakh Crs.
At this juncture, when rates may rise further, investments may be made in instruments that match the time horizon so that market fluctuations do not lead to loss of value and that a certain return is realized. Those who are already invested into very short term and short-term instruments may hold the same as the cushion of accruals as also expected accumulation will at some point ride over any potential depreciation, assuming that no very large movements, either way, happen in the market.

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