Wednesday, November 26, 2008

Outlook on Gilt Funds

Outlook on Gilt Funds

November 2008

Over the last couple of months, we have seen a reversal of the tightening interest rate cycle that began in 2004. However, unlike the gradual rise, the decline has been rather steep and quick. The 10-year-benchmark yield has breached 7.2%, down about 2.3% from the high witnessed in July on back of the change in the macro economic environment,fear of recession in major advanced economies, slowdown fears in EME’s including India and sharp fall in commodity prices. Reserve Bank of India has reduced Repo rate by 150 basis points, CRR by 350 and SLR by 100 basis points in a bid to ease the liquidity conditions and credit flow in the domestic market

With the focus of RBI shifting from inflation-containment towards growth, credit flow and liquidity management, we believe that in the medium term there will be bullish bias on interest rates due to the following factors

Inflation: Inflation has come off from its near-13% high in August-08 to single digits as commodity prices have sunk globally. International crude oil prices have declined by 65% from its peak levels and the CRB index stands at 233 almost 50% lower since its peak in the month of March-08. We expect WPI inflation to come down below RBI’s target band of 5%-5.50% before March -2008
Leading indicators pointing towards a slowdown: Index of industrial production for the month of August fell to a low of 1.4% on back of de acceleration in all the sectors. The average IIP growth rate for the period April-October 08 has been at 5.00% as against 9.30% in the similar period last year.
Money supply: Money supply growth, at 19% currently, has also come off from the high of 24% printed in January, closer to RBI’s target rate of 15%. A lower money supply reduces inflationary pressure on the economy.
Supply pressure has eased, additional borrowing to be calibrated with MSS Buyback: Supply pressure has considerably eased as the Government of India has completed its scheduled borrowing for the FY 2008-09. However the Government is likely to exceed the borrowing targets for the FY 208-09 considering the anticipated shortfall in the Budgeted revenue collection. Considering the overall interest rate outlook and RBI’s bias towards soft interest rates, additional borrowing will be easily absorbed by the market. The market will also take comfort from the fact that any additional borrowing will be calibrated by MSS buyback

International Interest Rate Scenario :On the global front Central banks across the world have resorted to accommodative monetary and fiscal policies by reducing policy rates, establishing dedicated credit lines for troubled institutions, announcing the biggest-ever government bailout packages for various sectors of the economy and trying to boost private consumption in various ways including tax breaks. Recessionary and credit squeeze concerns in US, Europe, Japan and rest of the world have led central banks to cut rates in consorted manner. USA which is considered to be the biggest growth engine of the world has reduced the short term rates from a high of 5.25% to 1.00% in last one year. The continued slowdown in the housing sector, employment levels, manufacturing, sales and private consumption numbers clearly point towards a contraction in the economy. The deceleration in US is causing ripple effect in Asian economies which are fast slipping in recessionary zone as their exports contract.

Outlook on gilt funds:

RBI’s focus has shifted towards growth, credit flow and liquidity management in light of the global developments and in a bid to protect the domestic financial markets from the seizure seen in the global credit markets in last few months. The recent statements from the finance ministry and RBI indicate that such expansionary policy would continue to rule the roost until the turmoil in the global market settles down and faith in the robustness of the financial system returns. Given the current economic scenario we believe RBI will continue to adopt an accommodative monetary policy and will ease policy rates significantly to stimulate growth.

Risks to our bullish view on government bonds

Sharp reduction on SLR ratio to infuse liquidity
Higher than expected additional government borrowing


Considering the present macro economic outlook, risk aversion and RBI’s accommodative monetary policy stance, we recommend investing in gilt funds with a one-year horizon

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