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Fixed Income Market View & Outlook

Overview FixedIncomeMarkets Increasing risk to growth, moderating industrial production, decelerating inflation, expected rate reversal by RBI and deteriorating government finances were the key highlights of the month. Globally, improved manufacturing activity, some progress on Eurozone moving closer to fiscal consolidation and continued Greece debt-restructuring problem were the highlights of the month.

Macro Overivew: Global Macro Overview: Downside to global growth risk diminishes, Eurozone moves closer to fiscal consolidation Global Manufacturing Purchasing Managers Index (PMI) in Dec 2011 suggests that the weakness in global manufacturing is starting to diminish. It rose 1.1 points to 50.8 in Dec 2011 - the highest since June 2011. The economic data from US was encouraging as industrial production, housing activity and consumer holiday spending showed signs of improvement. US unemployment rate has also come down. In the recent US Federal Open Market Committee (FOMC) meeting, it was stated that Fed expects to maintain federal funds rate at 0.125% at least through late 2014. In Euro area, the leaders of 25 European Union governments agreed on a historic pact to move closer to fiscal union and signed off on the details of a permanent bailout fund for the euro zone. There was still no clarity on Greece's looming debt restructuring.

India Macro Overview: Increasing risks to growth, moderating inflation, expected rate reversal by RBI and deteriorating Govt of finances In the third quarter policy review on Jan 24th 2012, the RBI cut the cash reserve ratio (CRR) by 50bps to 5.50%, while keeping the key policy interest rates unchanged. RBI had earlier indicated in its October policy review that it is done with its tightening cycle and accordingly maintained status quo in December. It was the first rate cut since RBI started hiking in 2010. A 50 bps CRR cut is expected to release about Rs 32,000 cr of liquidity into the system. Liquidity had been extremely tight recently with banks borrowing to the tune of Rs 120,000 140,000 cr daily from RBI - twice the amount that RBI is comfortable with. Liquidity may remained tight inspite of RBI conducting Open Market Operation (OMO) purchases (buying Gsecs) of around Rs 72,000 cr. It was partially due to forex intervention of RBI in recent months. Also, the upcoming state elections have resulted in increase in currency with public. So, RBI needed to ease the structural pressure in liquidity. A tight liquidity condition, above a threshold, restricts the flow of credit to productive sector harming growth which is anyway slowing. Continued tight liquidity has prompted RBI to restart OMO. Another CRR cut is expected by March 2012. Higher government expenditure, RBI steps and slower credit growth will support liquidity going forward. The central bank revised downward the FY12 GDP estimate to 7% from 7.6% on slower investment, weak industrial production along with global uncertainties. Growth decelerated due to fiscal profligacy combined with monetary tightening, policy paralysis and poor confidence. Growth next fiscal will also remain muted.

February,2012

The RBI remained worried about inflation and retained its March 2012 inflation estimate at 7% despite significant downward revision to growth. The recent fall in WPI to 7.47% yoy in Dec 2011 from 9.11% in Nov 2011 was due to high base and sharp fall in vegetable prices. But the structural supply side issues in protein based food items remained. Inflation is expected to moderate further to around 6.8% to 7% by March 2012 end. There are risks from suppressed inflation as impact of rupee depreciation is yet to be fully felt. Further, if the administered fuel prices are raised after state elections, headline inflation might not come down to RBIs acceptable level even after March 2012. However, inflation next fiscal may be still much lower than this fiscal on aggressive rate hikes, stabilizing global commodity prices and moderation in economic growth. The need for tighter fiscal policy is being talked about for some time now. Fiscal deficit in FY12 may be much higher, as government has already borrowed around Rs 93,000 cr more than budgeted. Fiscal deficit till Dec2011. this fiscal has already reached 92% of budgeted estimate. There may be considerable uncertainty over the fiscal consolidation next year too without any reforms on subsidy. The central government borrowing next year may be around the same, if not a little higher, than this fiscal. One-off gain from expected 2G auction next fiscal might reduce pressure. Fixed Income Overview The bond yields rallied immediately after RBIs CRR cut on Jan 24th 2012 and touched a low of 8.08% but sentiment turned bearish on inflation worry and absence of OMO purchase indication in the policy statement. 10-yr benchmark yield moved back to 8.35%. However, by end of the month, continued liquidity tightness inspite of CRR cut, this may led to announcement of OMO purchases again. Benchmark yields eased to 8.28% as on 31st Jan 2012. The 10-yr G-sec yields had softened 28 bps since end Dec 2011. The 10 year benchmark G-Sec was on an average 8.26%. Corporate bond yields softened taking cues from G-Secs, with 10 year AAA closing the month at 9.30% as against the previous months close of 9.44% and 5 year AAA closed at 9.43% (Previous month: 9.48%). In money market, the CD yields moved up during the month on tight liquidity with 3 months, 6 months and 1 year CDs closed the month at 9.98%, 9.95% and 9.95% as against 9.57%, 9.65% and 9.74% at Dec 2011 end. 1 year Overnight Interest Swaps (OIS) and 5 year OIS were trading at 8.16 % and 7.30% at month end as against 7.75% and 7.10% at end of December 2011. Fixed Income Market Outlook In the policy, the RBI has hinted that the further policy actions will depend on trend in core inflation and governments credible, sustainable fiscal consolidation numbers. Going forward, G-sec market may take cues from OMO auctions, policy makers statements, liquidity scenario and hi-frequency key macroeconomic data points like growth, Wholesale Price Index (WPI),Index of Industrial Production (IIP), credit numbers etc. Global developments like crude oil price, situation in Iran, Euro crisis, Central banks statements and actions will be closely watched. Liquidity in February might ease from previous month on Government expenditure and further OMO by RBI. Yields on short term bonds are expected to remain range-bound. Common Source for Fixed Income View: RBI, Bloomberg, CMIE

February,2012

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February,2012