Space for RBI to cut rates

Enthused by positive comments and clarifications by the finance minister and other authorities, fixed income markets shrugged off the disappointment of the last week and started on a positive note.  The government reiterated its commitment to fiscal consolidation and also clarified the position on GAAR assuaging concerns of international investors. The FM also indicated that the final fiscal deficit number for FY13 may be even lower than 5.2%.

Further, concerns on a large borrowing programme were mitigated by suggestions of inflation linked/floating rate bonds as also by the possibility that the extra borrowing to smoothen large redemption in subsequent years would depend on market conditions. Support also came from global markets where statements from rating agencies reflected a positive view on the budget and when oil prices declined for the week. Finally the news of a sharp increase in Chinese exports for last two months provided fresh evidence of an improving global trade environment igniting hopes for better current account deficit scenario. Bond traders were also hopeful of a positive discussion on space for further rate cut during the customary meeting of FM with the Reserve Bank of India board following the budget.

The benchmark 10-year government bond yields declined 7 basis points (bps) to close at 7.84%. Money market rates on bank CDs for both three months and one-year also eased by about 25 bps. In a more significant evidence of renewed optimism, corporate bond spreads contracted for the first time in the current year by 5-7 bps across the curve. Corporate bonds were also supported by a change in investment norms for insurance companies this week where a minimum of 15% is to be invested in bonds of infrastructure and housing finance companies. The markets closed the week on a very firm note indicating a further uptick at open in next week.

Most analysts after a detailed analysis of the budget and the macro environment are now opining of an increased space for RBI to cut repo rate further including in March policy review. Bond prices are likely to inch up further next week to retest the recent highs. However, given the recent volatility and approaching year-end, some profit booking cannot be ruled out. A new high is possible if traders start pricing in a 50 bps rate cut in March policy. Money market rates may harden again ahead of the advance tax outflows in anticipation of tighter liquidity.