Saturday, December 18, 2010 11:22 Hrs IST

We Believe That Money Market Rates Are Likely To Remain Subdued In the Near-Term

Credit Policy Views - Dhawal Dalal, Senior Vice President, Head – Fixed Income, DSP BlackRock Mutual Fund

The RBI, in its mid-review of credit policy on 16 December, has announced the following steps:

• No change in Repo Rate (6.25%) or Reverse Repo Rate (5.25%)
• No change in Cash Reserve Ratio (6%)
• SLR cut by 1% to 24% effective 18 December 2010. This measure has a potential to add Rs. 48,000 crore to systemic liquidity
• RBI has announced a bond buy-back amounting to Rs. 48,000 crore (Rs. 12,000 crore per week starting Dec 24, 2010)

Money Markets:

Money market participants welcomed the news of the bond-buyback announcement as this measure may help increase systemic liquidity by the same amount. 3M Bank CD yields dropped from around 9% p.a. pre-policy level to around 8.90% p.a. post-policy as market participants rushed to utilize their cash to buy bank assets. Market participants are of the view that current levels of bank CD yields may not sustain, if systemic liquidity eases going forward. 1Y Bank CD yields have also dropped by around 10 basis points to 9.50% p.a. after the announcement.

We believe that money market rates are likely to remain subdued in the near-term (at least till the year-end) as market participants focus on deploying their surplus liquidity in the money market assets, amid a reduction in the supply pressure. We believe that Mutual Funds are maintaining a relative high level of cash and short-term assets.

As compared to 3M PSU bank CD @ 8.90% p.a., we prefer April 2011 PSU bank assets at around 9.40% p.a. as well as 1Y PSU bank assets at around 9.50% p.a., which offers 200 basis point spread over 364-Day T-Bills.

Government Bonds:

Government bonds experienced a relief rally due to no rate hikes (as some had feared) and the announcement of bond buy-back program. The benchmark 10Y bond yield dropped 3 basis points to 8.02% p.a. while the widely traded 12Y benchmark bond has experienced a 5 basis points decline after the news.

We expect government bond prices to rally gradually from here, as market participants look to cover their shorts and deploy surplus cash (from previous bond buy-backs) into liquid government bonds. We like the long-end of the curve (15Y+) at 8.42% p.a. which offer relative value over the benchmark 10Y bond currently.

Swap Curve:

Swap rates have dropped by 5 to 15 basis points across the curve after the policy announcement. They had risen nearly 5 basis points on 15 December.

Corporate Bonds:

Corporate bonds are likely to witness further supply in Q4 as government bond supply diminishes in Q4. We also expect FII inflows to increase in the new year starting 1 January 2011.

Systemic Liquidity:

The RBI has sent a powerful message to the market. We believe that systemic liquidity will ease going forward, albeit, in batches. We do believe that the RBI may take further steps to infuse liquidity as and when needed. However, we believe that the RBI may continue to remain hawkish on rates and may hike rates in the next credit policy meeting, due in 25 January 2011, if commodity prices continue to rise.