The month of April,2012 saw moderation in domestic growth and core inflation, leading to front-loading of policy rate cut by the RBI. Huge scheduled government borrowing (with risk of fiscal deficit slippage) has put pressure on G-Secs (with 10 year benchmark yields moving in the band of 8.34% and 8.74%) and has led to credit rating agency like S & P downgrading India outlook. Rupee continued to remain weak on widening current account deficit and FII selling.

On global front, expectations of slow improvement in global growth in 2012 as reflected in slowly improving growth in US and muted growth in emerging economies. However, underlying risks in Euro zone with UK already into recession are the key downside risks to global growth.

According to IMF, the growth prospects of the global economy are slowly improving. World GDP is set to rise by 3.5% this year and by 4.1% in 2013. Emerging markets will contribute more to growth. The IMF sees several risks ahead: the euro crisis and fiscal austerity in the rich world, upheaval in the Middle East and the possibility of a hard landing in countries like China which have seen exceptional credit growth.

The US economy expanded at an annual rate of 2.2% in Q1 - less than the expected 2.5%, but the consumer spending accelerated in Q1CY12. The Fed appeared more optimistic about the prospects for US economic growth and jobs this year than at a previous meeting in Jan. However, Ben Bernanke, warned that it is "a little premature to declare victory". The Fed intends to keep interest rates near zero until the end of 2014.

Against the backdrop of constructive growth dynamics in North America and Asia, the Euro area stuck out like a sore thumb. The euro-zone crisis resurfaced amid worries that Spain will be unable to keep its public finances under control and will require a bail-out at some point. The yield on Spanish ten-year bonds rose to almost 6%, the highest since the ECB’s first provision of cheap funding for banks (LTRO) in December, which had calmed bond markets. Yields have moved lower by end of the month but underlying structural problems remain. Upcoming elections in several Euro economies have complicated things. Also, Britain's economy has returned to recession, as the economy contracted for a 2nd consecutive quarter.

India Macro Overview: Suppressed risk to inflation, limited scope for large rate cut by RBI, and high Govt borrowing

Industrial production in Feb’12 at 4.1% yoy was better than 1.1% in Jan, but lower than consensus expectation of 6.7%. It was disappointing to see major data issues in IIP numbers. The Jan number of 6.8% announced earlier was revised down to mere 1.1% as non durables (food, beverages etc) growth was lowered sharply from 42.1% to 11.0% due to error in reporting of sugar output. Consumer durable growth continued to disappoint in Feb as high interest rate effected domestic demand. But Capital goods in Feb improved after months of contraction, helped by base. Overall IIP was still low – growth in Apr-Feb was at only 3.5%. Ground level investments have not picked up. Poor industrial production will pull down growth in 4Q resulting in lower than 6.9% estimated growth for the full fiscal year FY12.

The WPI inflation for Mar’12 was a little higher than consensus expectation of 6.7%. Inflation still remained a tad below 7% - RBI’s target for Mar-12. Mar inflation was driven by Primary articles. Contribution of Primary articles to monthly rise in inflation was high around 70% in Mar. Core inflation came below 5% after two years (4.6% in Mar vs 5.7% in Feb) – partly helped by base. There are risks to WPI from revision of fuel price, electricity tariff hike, increase in indirect tax and weak rupee. The inflation trajectory expected to remain around 7% to 8% in FY13.

In its annual policy meeting, the RBI surprised the markets with an aggressive 50 bps Repo rate cut as against an expectation of 25 bps. This is the first rate cut after more than three years. RBI had earlier cut CRR 125 bps since Jan’12 to ease liquidity. RBI front-loaded the rate cut and took advantage of the window of opportunity made available by slowing growth and moderating core inflation. GDP growth in FY13 is projected at 7.3% and WPI by Mar-end 2013 projected at 6.5%. More importantly, RBI mentioned that India’s new potential or trend growth has come down to around 7.5%. RBI’s forward guidance was more cautious - lower potential growth, upside risks to inflation and fiscal slippage by government “inherently limit the space for further reduction in policy rates.” RBI indicated that it will very proactively manage liquidity keeping banks LAF borrowings within +/- 1% of net demand and time liabilities (NDTL).

Standard & Poor revised the credit outlook on India to negative from stable; while reaffirming BBB- rating. S&P said that the widening current account deficit, slow progress on fiscal consolidation and slowing growth were the factors responsible for such a revision. The revision also reflected a one in three possibility of a downgrade if above conditions deteriorated further.
  The INR continued to remain under pressure in April, depreciating by around 3% over the month against US dollar. Sentiment turned bearish on India’s weak economic outlook and fears of more pain given limited fiscal and monetary space for supporting growth. INR is expected to remain weak as the current account and balance of payments situation is not at comfortable level. Recent S&P downgrade also hurt INR.

Liquidity in the system improved in April as compared to March but not as much as expected. Net LAF borrowing came down to around Rs 100,800 cr in April vs. Rs 157,400 cr in March. The historical trend of high government spending in April was, however, not observed this month.

Fixed Income Overview 10-yr benchmark yield moved up at the start of the month touching 8.74% tracking large size of weekly G-Sec auction and devolvement in the first G-Sec auction of the financial year. However, Gsec market rallied after softer IIP and core inflation numbers and higher than expected Repo rate cut of 50 bps by RBI. Yields touched a low of 8.34% by April 17th. The sentiment in the market turned bearish again after the euphoria of rate cut was over. Yields started rising on expectations of new benchmark G-sec, large supply, news of FII selling on account of changes in taxation rules and downward revision of India’s rating by S&P. The benchmark 10-year security ended the month at 8.67% - hardening of 10 bps since end-Mar. The 10 year benchmark was on average 8.55%. The yield curve which was inverted till March, 2012 has flattened. The short end of the curve moved lower on RBI rate cut and improvement in liquidity. Corporate bond yields softened, with 10 year AAA closing the month at 9.44% as against the previous month’s close of 9.50% and 5 year AAA closed at 9.44% (Previous month: 9.54%).

In money market, the CD rates eased during the month with 3 months, 6 months and 1 year CDs closed the month at 9.60%, 9.80% and 9.75% as against 10.80%, 10.70% and 10.35% at March end (Generally, the CD rates shoots up in March every year on account of huge issuances at financial year end). 1 year OIS and 5 year OIS were trading at 8.02 % and 7.64% at month end as against 8.06% and 7.59% at March end.

Fixed Income Market Outlook RBI is not expected to cut rate in near future (next policy meet is on June 18th). However, the possibility of rate cut remains and will be primarily data driven. No aggressive action from RBI is expected unless growth disappoints significantly. Risk to inflation increases from indirect tax hikes, impending retail fuel price increase, raise in electricity tariff and uptrend in food prices in summer. Going forward, G-sec market will take cues from policy makers’ statements, liquidity scenario and hi-frequency key macro-economic data points like WPI, IIP, credit numbers etc. Global developments like crude oil price, Euro problems – particularly in Spain and Italy, Central banks’ statements and actions will be closely watched.

Liquidity in May will ease on higher government expenditure and large maturities. RBI is expected to manage liquidity proactively. These will certainly help the yield curve steepen by short to medium end falling. However, rupee movement will be data point keenly watched. There is a low probability that there will be any immediate rally in G-secs on back of huge G-sec supply lined up (along with state loans borrowing).

Common Source for Fixed Income View: RBI, Bloomberg, CMIE

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