January 2011 Debt Newsletter: Liquid funds will yield better returns in very short term
Invest at the extreme short end of the curve to capture rise in short end yields leading into March 2011, where liquidity will get extremely tight. An inverted yield curve does not necessarily mean a safer yield curve and short term funds are to be avoided. Credit spreads at around 100 bps have more room to move up given tight liquidity conditions and expectations of policy rate hikes by the RBI in end January 2011. Government bond yield curve is distorted due to RBI purchase of bonds and does not reflect rising inflation expectations, tight liquidity conditions and rising bond supply. Gilt funds will not perform well in this environment.
Liquid funds offer the best positioning at the extreme short end of the curve. The curve is unlikely to steepen soon given expectations of continued liquidity tightness. Banks will be raising deposit rates to counter slower deposit growth even as credit growth is strong. Banks raising deposit rates will push up cost of funds for corporate leading to rising credit spreads. Short and medium term funds having exposure to credits will continue to fare poorly as well carrying high liquidity risk. Long end corporate bonds is segmented with demand emanating from provident funds, but given tight credit spreads yields are unlikely to come off. Income funds with their high costs will perform poorly on the back of rising government bond yields as well as rising credit spreads.
Interest rates in India are set to rise further on the back of inflation and liquidity concerns. Policy makers are unable to bring down rising inflation expectations while banking system liquidity is in deep negative territory with banks borrowing funds from the RBI on a daily basis. Rising inflation expectations and tight liquidity conditions have a negative impact on interest rates with rising cost of funds for the banks driving up interest rates on loans as well as driving up bond yields.
Inflation as measured by the WPI (Wholesale Price Index) is expected to end March 2011 at around 6.5 per cent levels with an upward bias. Policy makers were hopeful that inflation could be brought down to below 6 per cent levels but that seems farfetched given that primary article inflation is trending at over 17 per cent and rising fuel prices is raising inflation expectations. Oil prices at over $90/bbl is at over two year highs and this is feeding into inflationary pressures in the economy either directly through rise in fuel prices or indirectly through rise in fiscal deficit due to higher fuel subsidies. The government is looking to raise the MSP (Minimum Support Price) for crops and this is inflationary in nature as it stokes demand for goods and services. Commodity prices such as copper and aluminium are also rising due to demand from China which continues to buy large quantities of such commodities. The rise in commodity prices will be passed on to consumers in an economy where consumer demand is increasing due to the government’s inefficient spending policies. The rise in prices of manufactured products will show up in overall inflation leading to rising inflation expectations.
Liquidity has tightened in the banking system over the last nine months. Banks which were lending over Rs 1,00,000 crore to the RBI in April 2010 is now borrowing over Rs 1,00,000 crore from the RBI on a daily basis. Banks deposit growth is growing at 14.7 per cent year on year growth while credit growth is growing at 23.7 per cent year on year. The gap between deposit and credit growth is leading to a net drawdown of liquidity by banks. The RBI is constrained on liquidity easing measures due to inflation and while they have been buying bonds from the market to add primary liquidity they have not reduced the CRR (Cash Reserve Ratio). Liquidity outlook is negative for the near future.