The fixed income market has been extremely calm and traded within narrow ranges for more than two months now. This is the result of an accommodative policy and a liquidity glut occasioned by the expansionary policy. The rates on commercial papers and certificate of deposit has come down to low single digit levels, to levels between 3 % and 4 %, and this is in sharp contrast to the levels of 8 % to 9 % , where they were perched for years. This has resulted in substantial cost reduction as far as corporates are concerned. It may be virtually impossible to imagine costs falling much lower than this. The liquidity which is aplenty has driven the short end yields to these levels.
The paradox of the situation is that this kind of low yields would necessarily result in lower returns from investments at the very short end of the curve. In other words, the return expectations from the short end of the curve needs to be moderated due to the lower yields especially for those who are entering the market at the current levels. But this does not make a case for investing at the long end of the curve because the risks of reversion in yields is higher at the long end.
What are the factors that should be kept in mind while making fixed income investments? The primary thing is the continuous issue of government securities both central and state governments, which has been putting pressure at the long end of the curve. The announced borrowings will get over by Jan,2021. But it is expected that there may be additional borrowing hitting the markets in Feb and March too. This expectation also caps the advancement which the market can make based on a comfortable liquidity position.
The level of inflation indicated by CPI has risen to 7.61%, much higher than the RBI threshold of 6 % for monetary management. The rise is inflation is mainly due to the rise in food prices. Initially it was due to fruits and vegetables, but the latest data shows the spread of inflationary spiral into other food items as well. Therefore, it may not calm down too soon. Brent has been rising all the while in the last one month. From US$ 40 it is just a stone’s throw away from US$ 50 per barrel. The higher fuel prices may also impact the domestic price level and keep the higher prices sustained at higher levels.
The fundamental approach of the RBI in the current times has been one of pro-growth, and with that approach intact it is less likely that RBI would hike interest rates any time soon, while the scope of a cut in rates may be entirely ruled out. But the potential for curtailing liquidity is an option which the RBI may consider if inflation persist. This may signal the first move for a reversal in rates. But this is not an easy choice for the RBI when the economy is yet to come out of a severe demand destruction and job losses cased by the pandemic and the lockdown. Much would also depend on the trajectory of the second and third wave of the pandemic.
The focus on short term products is the most viable option based on risk adjusted returns. The evolution of the RBI policy as well as the actual dependence of the government on the markets in the last quarter, are things to be watched very closely.
