Rupee slide unlikely

The rupee dropped over 15 paise during last week, closing at 43.47 against the dollar-the lowest ever closing level in this fiscal. The movement has been on the back of merchant demand as speculative activities have been limited. Capital inflows continue to be strong and the rupee is unlikely to drop sharply from current levels.

Tighter liquidity to impact T-bill cut-offs

The 14-day treasury bill cut-off yield rose to 8.63 per cent and the 91-day treasury bill yield to 9.11 per cent. The 182-day treasury bill wasauctioned before liquidity tightened; the cut-off yield at 9.34 per cent was 57 basis points lower than the previous auction. Tighter liquidity is expected to impact the 364-day treasury bill auction adversely.

Gilts market runs up sharply

Gilts prices ran up sharply in the first half of last week. One-year yields dipped to 9.95 per cent, five-year 10.90 per cent, 10-year 11.46 per cent and 14-year 11.80 per cent. The price-based auction of 11.99 per cent 2009 security also attracted large participation and the cut-off price was pegged at Rs 102.90 (11.48 per cent yield).

The price rise was capped after the auction and the Reserve Bank placed two securities on the OMO sale list. The 12.40 per cent 2013 security which dealt at Rs 104.06 on Thursday was priced at Rs 103.80 at the OMO window. Consequently, prices dropped by 10-15 paise across the maturity spectrum. Tighter liquidity has impacted security prices; however, market sentiment has not yet turned negative. We do not see a large downsiderisk to prices in the immediate term. The rally could continue if liquidity eases this week.Many market participants have been expecting a reduction in bank rate coupled with a cash reserve ratio (CRR) cut since July. The arguments rested on two major assumptions: One, RBI would take steps to bring the interest rate structure lower. Two, CRR would be reduced over the year by one to two per cent, and the critical decision would be the timing in order to have the maximum impact on interest rates.

Current indications appear to reduce the probability of a rate cut in the immediate term. Capping the price rise by placing the 12.40 per cent 2013 security at the OMO window slightly below prevailing market prices immediately after the outflow of Rs 3,000 crore government security issue has dampened the sharp rally.

It appears that the RBI's focus is on "stable" interest rates and not on "declining" interest rates. Reduction in CRR is likely to be held back till there are clear signs of credit pick up. Theemphasis would be on ensuring that the corporate sector obtains credit at reasonable interest rates. However, banks are unlikely to reduce PLRs as their spreads have already been squeezed after the last rate cut effected in March.

At the risk of repeating ourselves, we reiterate our view that linkage of nominal interest rates to the current low level of wholesale price index (WPI) based inflation (to reflect "real" interest rates) is tenuous, as the low WPI is a statistical anomaly due to the high base of last year. Lower rates would be indicated only if it is believed that the low level of inflation is sustainable.