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The surge in inter-bank liquidity compelled the Reserve Bank of India (RBI) to announce surprise measures with a retrospective approach. The increase in the cash reserve ratio (CRR) maintained by banks for the past period will halt the softening of yields temporarily, says India Ratings and Research (Ind-Ra). The 10-year G-sec yield could trade at 6.25%-6.35% (6.23% at close on 25 November 2016) through the week, with a possibility of a near-term cap at 6.4%. The rupee is likely to trade at 67.95/USD-68.85/USD (68.47 /USD at close on 25 November 2016).
CRR Hike to Suck out INR3.5trn: Ind-Ra believes that the measures are taken with an aim to blot out the excessive liquidity in the system triggered by denotification of currency notes; however it will deprive banks of the discretionary allocation of the deposits, constraining their ability to utilise these deposits and increasing the carrying cost. The move will mop up a substantial amount of liquidity (current liquidity surplus at around INR5.3trn) without the need of collateral or a higher cost from RBI.
Bond Yields to Spike: Ind-Ra believes the latest measures will act as a significant sentiment dampener, and also change the demand-supply balance in the system. The impact will be more visible at the shorter end of the curve.
After the current measures, the markets' expectation of a rate cut in the upcoming monetary policy review could also face a downward revision, further weighing down on the bond market. This could lead to the widening of spreads between G-sec and corporate bonds, as near term investor appetite will remain weak.
Rupee Weakness to Stay: Ind-Ra believes, in the event of hardening US treasury yields and buoyant financial sentiment in US, emerging market currencies are in period of correction, and the rupee will not be an exception. Foreign investors have been pulling out money from both debt and equity segments - with total net outflows clocking USD4.4bn in November 2016. Globally, the next non-farm payroll data will be critical prior to the Fed's policy review in December. With near consensus among market participants about the Fed rate hike in the upcoming December policy, rupee weakness will continue in the near term. However, if volatility surges, potential intervention by RBI will rein in the rupee weakness.
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