Debt Market Outlook: Repo rate may be hiked further

US Fed's decision to defer tapering has given RBI enough elbow room to stabilise rupee and reverse monetary tightening measures in a gradual fashion

Over the past few weeks, India's external balances (trade gap and current account deficit (CAD) have improved materially even, as foreign capital flows have turned positive.

The decision of the US Federal Reserve to defer its QE tapering for the time being has given the Reserve Bank of India (RBI) enough  room to stabilise the rupee and reverse the monetary tightening measures in a gradual fashion. The latest RBI policy review (October 29) should be viewed in this backdrop.

The second quarter policy review   was largely on expected lines. RBI increased the repo rate under the liquidity adjustment facility (LAF) by 25 basis points to 7.75 per cent. This was the second hike in the rate under new RBI governor Raghuram Rajan, as the central bank continues its efforts to bring down high consumer prices (measured by the Consumer Price Index ). Even inflation under the WPI series has inched higher of late.

Besides the repo rate hike, RBI eased the Marginal Standing Facility (MSF) rate by 25 basis points to 8.75 per cent with immediate effect. The spread between repo and MSF rates has been normalised to 100 basis points and the interest rate corridor has re-aligned.

Since September 20, the RBI has slashed the MSF rate by 150 basis points cumulatively as part of its aim to normalise liquidity in a calibrated manner, and hiked the repo rate by 50 basis points in light of elevated inflation and high inflation expectations.

RBI, in its latest policy review, introduced a measure to infuse liquidity into the system; it has doubled the notified amount under 7-day and 14-day term repos to 0.5 per cent of Net Demand and Time Liabilities. This is expected to infuse Rs 20,000 crore of liquidity on a daily basis and likely to bring down the average funding cost in the banking system. It will also help reduce money market rates because with increase in borrowing caps under term repos, dependence on MSF will decline.

Meanwhile, FIIs have been net sellers of Indian fixed income securities for the past few months. They sold Rs 13,000 crore worth of government and corporate bonds in October. They have sold nearly Rs 50,000 crore worth of Indian fixed income securities year-to-date.  In addition, November is likely to witness the auction of Rs 75,000 crore government bonds. There might be an additional supply of Rs 10,000 crore of State Development Loans. We believe this supply pressure might keep government bond yields elevated. We expect the benchmark 10-year government bond yield to trade between 8.45 per cent and 8.75 per cent in the near term.

The government is reported to be in talks with various international fixed income index providers for inclusion of its sovereign bonds in their indices. Any positive outcome on this front will have a positive impact on the domestic debt markets and will result in reversal of FII outflows.

Taking into account the recent RBI measures on improving liquidity, the overnight rates might moderate and gradually move closer to the repo rate. Though MSF remains the operative rate, impending RBI steps to improve liquidity will eventually make the repo the key operative rate.

For investors, it makes sense to invest in low-duration debt instruments for short-term purposes. For longer term investments, we prefer quality of debt instruments over yield. Also, with respect to risk/reward, it is not advisable to buy low credit quality papers.

On monetary policy, the RBI guidance continues to be hawkish, even as CPI is gaining precedence over WPI in the monetary policy response. Given that the end-FY14 inflation will likely be above RBI's comfort zone, further increase in the repo rate cannot be ruled out.

The central bank could hold short-term rates at the current levels or lower depending on the trajectory of CPI going forward. Concurrently, the RBI will try to ensure favourable liquidity conditions. In the near term, the Indian debt markets will broadly focus on inflation, FII flows, RBI OMOs, demand-supply dynamics and inclusion of government bonds in international bond indices.

The author is head - research, retail capital market, Edelweiss Financial Services