Few Macro Environment Indicators:

Liquidity – Overall the domestic banking system is running liquidity deficit of aprox ~150k cr as measured by the daily LAF numbers, this can be attributed to increase in currency in circulation, Government borrowing and RBI intervention in forex market (selling dollar to stem sharp depreciation in rupee eventually taking rupee liquidity from the market) the government borrowing makes system negative for a very short span of time as the Govt is spending more that it borrows which can be seen in WMA figures. As far as forex intervention is concerned though RBI has done intervention of aprox 15 Bn $ i.e 75k cr which has contributed to the tightness. However a similar amount of OMO purchases also have been done and aprox 32k has been released thro CRR. RBI has been showing commitment to bring the total liquidity deficit to aprox 50k and will continue to take measures to achieve the same

Inflation: We have seen sharp deceleration in headline monthly WPI numbers and we expect the same to continue in future we expect the headline WPI to be between 6.5% to 7.5% by March 2012 which is close to RBI Comfort zone. The key drivers to high inflation were Primary articles, food and fuel inflation were key drivers to high inflation. Over the period of last one year RBI has taken various measures to contain inflation and inflationary expectations. Going forwards the RBI stance will be pro Growth and the core inflation data will be key driver for the rate cuts to come but its just matter of time. High Oil prices remain a risk to our Inflation estimates and RBI actions to promote growth

Growth: We have seen growth deceleration in GDP numbers (2nd quarter GDP has printed below 7%) which is similar number to the credit crisis in 2008. The only question is how deep it will go and how prolonged it will be?
The first line of defense to stem growth deceleration is by releasing liquidity which has already started by OMO (Purchase of G Sec). So far the RBI has injected around 75 to 80cr thru OMO buyback and is expected to announce incremental OMO’s of aprox 20-30k. It is likely that this process would continue for to assuage the liquidity issue and the rate cuts will follow we expect 100 bps rate cuts over the course of next one year.

Bonds Spreads: The underlying risk free curve has seen sharp down move due to the various factors mentioned above and the corporate bond curve did not follow suit resulting in widening of spread on the long end. At the short end, in the 6m- 18m segment, the NBFCs are offering reasonable spreads (around 160-200 bps) which is attractive given the shape of the curve. From risk reward perspective when the short end is much higher then long yields, then its better to be at the shorter end. When the curve steepens ( bull or bear steepen), one stands to gain and also benefit from the roll down effect

Impact- The Impact of the above situation can be seen in the bond Yield curve which has become almost flat to inverted which means that market believes that the tightness in liquidity will be short lived. The guidance given by the RBI on liquidity was that they are comfortable with +/-1% of NDTL which means the desired number should be around 50,000-60,000 cr. In case the number deviates either side the market expects that the RBI will do something to infuse liquidity. To this effect, we believe that the RBI is likely to conduct around 20-30k cr worth of OMO to give comfort to the market. By doing the OMO they are able to solve the twin objective of anchoring the rise in government yield curve as also providing liquidity.