LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN

MASSIVE DECLINE IN YIELDS BOTH IN CASH AND DERIVATIVE SEGMENTS

The 10-year Government security yield fell to 6.16% on December 12, 2008 from a high of 9.47% established in July 2008. 5-year OIS rates declined 548bp to 4.88% from the peak set in June 2008. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index descended to 8.95% from the crest on November 11, 2008. The growth-inflation picture for 2009 suggests that the long bond trade will continue to deliver returns in the foreseeable future.

EXPECT BELOW POTENTIAL INDIAN GROWTH IN 2009 AND 2010

U.S., Europe, and Japan remain in a recession. Sharply slowing export data (-2.2% in November 2008) from China point to lower growth in times ahead. Consensus expects a tepid global recovery in the second half of 2009 at the earliest.

Indian industrial production numbers for October 2008 registered a 0.4% y/y decline. While the Indian economy is relatively closed with exports/GDP of just around 20%, the secondary sector depends on global demand to a large extent. Manufacturing expansion in 2009 will be challenged by underperformance of external spending. And services will not be immune due to inter-sectoral linkages (Sustainability of Services-Led Growth: An Input Output Analysis of the Indian Economy; 2003 RBI Occasional Papers). Capex will be the next casualty as capacity utilization falls. Bottom-line, 8% real GDP growth will not be seen for at least the next couple of years. Expect readings in the vicinity of 5% instead.

INFLATION TO AVERAGE SUB-5% IN 2009 AND 2010

Although headline WPI and various measures of CPI appear elevated, the outlook figures positive in view of weak world expansion prospects and the substantial decline in commodity prices. International factors drove bulk of the local price escalation over the last 4-years, with the largest contribution coming from fuel and metals. The Baltic Dry Index fell off the cliff in 2008, as did the CRB index. Resurgence looks unlikely in the foreseeable future.

BELOW POTENTIAL GROWTH AND SUBDUED INFLATION = AGGRESSIVE MONETARY EASING

How much of a difference six months can make! Global central banks quickly changed gears from fighting inflation to supporting aggregate demand. The Fed will cut to 0.5% in the coming week. The effective Fed Funds rate remains firmly below target due to quantitative easing. The ECB and BOE will maintain their aggressive easing bias. Monetary authorities will probably over ease to prevent deflationary expectations from taking hold and to counter de-levering induced bloated risk-spreads.

The RBI also acted with alacrity to reduce borrowing costs. Expect more of the same. The Reserve Bank will likely cut the reverse repo rate by at least 100bp over the next 6-months.

PERSISTENT EXCESS LIQUIDITY TO BE THE NORM

The quantum channel of monetary policy retains importance in India. The RBI will keep the economy flushed with money. Additionally, assuming an incremental capital output ratio of 4, a 5%-6% real expansion will require funding of the order of 20%-25% of GDP. The domestic savings rate of plus 30%, clearly in excess of the economy’s absorptive capacity; will adjust lower in a dis-inflationary fashion. The process will manifest in the banking system in form of high time deposit growth and slowing non-food credit ascension. The result – enduring excess deployable funds. The call rate will hug the reverse repo as a result. The end-game would be an increasing investment to deposit multiple. The combination of low yields, excess liquidity and a positive rate outlook would trigger a chase for yield leading to lower term and credit spreads.

YIELDS WILL CONTINUE TO SLIDE

In the scenario outlined above, sub-4% 5-year OIS rate is a clear possibility. Yet going forward, most of the rally will manifest in the cash segment. The previous low for the 10-year Government security yield (4.94% in 2003) will most likely be broken.

MOST OF THE OPPORTUNITY LIES IN CORPORATE BONDS

The maximum upside trade would be going long a diversified basket (with issuer due diligence) of AAA corporate bonds. Nominal spreads over treasuries on FIMMDA Bloomberg 10-year AAA corporate bond index descended to 279bp from 416bp on November 6, 2008. The average yield over term-matched local treasuries since December 5, 2001 measures 105bp. Clearly, there is still a lot of room for price appreciation in high quality corporate paper.

To summarize, despite a significant decrement in yields already; the economic outlook suggests still more downside. The risk reward appears better for cash bonds versus swaps. Within the cash segment, high quality corporate bonds would reward fixed income portfolios most in the times ahead.