Forex forward rates decline further
The rupee stayed between 43.50 and 43.53 against the dollar through out the last week. The Indian unit is expected to stay in a trading range around current levels. Forward rates continued to drop. Six-month forwards ended the week at 3.65 per cent while one-year forwards closed at 3.86 per cent.

T-bill cut offs drop
The 14-day treasury bill cut off was at 7.58 per cent, while the 91-day treasury bill cut off was at 8.98 per cent. There was strong bidding interest in the 364-day treasury bill too and the cut off at 10.17 per cent was three basis points belowthe previous level. Liquidity appears comfortable till the end of the fiscal and prospects of call rates staying close to 8 per cent have led to increased interest in treasury bills.

Karnataka to auction SDL
Karnataka state will auction Rs 200 crore of 10-year state development loans on January 18. The issue size being small, full subscription is likely. The issue is likely to be subscribed about 20 to 25 basis points above the yield of 10-year gilts.

PPF, savings schemes rate cuts spur rally
Bond prices were stable for most of last week trading in a 10-15 paise range. Prices jumped in steps on Friday and Saturday following reduction in interest rates for public provident fund and postal savings schemes by 100 basis points. The spurt in prices has been very sharp. Yields of 10-year securities have dropped 20 basis points, 15-year by 22 basis points and 19-year by 19 basis points. At the peak, the longest security 12.60 per cent 2018 was quoting at 11.45 per cent yield.

Thus, the longend of the yield curve has dropped by about 20 basis points. The short end has not reacted much yet. As long as call money rates do not decline below 8 per cent, there would be stickiness to short term yields.

With the current market structure, where refinance at bank rate is continually drawn down, call money rates would continue to dictated by the bank rate. Hence, the question is what is the likelihood of a bank rate cut? One of the issues raised by RBI in the October 1999 monetary policy review was that "interest rates on contractual savings like provident fund, national savings schemes are substantially higher than long-term deposit rates of banks...priority needs to be given to remove some of the above constraints so that the interest rate structure can be made more flexible during different phases of the business cycle."

The current reduction does move in the correct direction, though on a tax-adjusted basis, the rates continue to be significantly higher than bank deposit rates. Given the currentreduction in administered interest rates, there could be a case for RBI to reduce the bank rate (enabling a general interest rate reduction including bank deposits and PLRs). Alternatively, this could be deferred after the union budget (raising the next question of whether employee provident fund would follow suit).

The probability of a bank rate cut would be strengthened if the Fiscal Prudence Act is passed. We are inclined to bet on the FPF rate being reduced in the budget followed by a bank rate cut. In such a scenario, maximum gains would be at the long end of the yield curve. Hence, we bias the recommended portfolio towards the long end.