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Overview FixedIncomeMarketsIncreasing risk to growth, moderating industrial production, decelerating inflation, expected rate reversalby RBI and deteriorating government finances were the key highlights of the month. Globally, improvedmanufacturing activity, some progress on Eurozone moving closer to fiscal consolidation and continuedGreece debt-restructuring problem were the highlights of the month.

Macro Overivew:

Global Macro Overview: Downside to global growth risk diminishes, Eurozone moves closer tofiscal consolidation

Global Manufacturing Purchasing Managers Index (PMI) in Dec 2011 suggests that the weakness inglobal manufacturing is starting to diminish. It rose 1.1 points to 50.8 in Dec 2011 - the highest since June2011. The economic data from US was encouraging as industrial production, housing activity andconsumer holiday spending showed signs of improvement. US unemployment rate has also come down.In the recent US Federal Open Market Committee (FOMC) meeting, it was stated that Fed expects tomaintain federal funds rate at 0.125% at least through late 2014.

In Euro area, the leaders of 25 European Union governments agreed on a historic pact to move closer tofiscal union and signed off on the details of a permanent bailout fund for the euro zone. There was still noclarity on Greece's looming debt restructuring.

India Macro Overview: Increasing risks to growth, moderating inflation, expected rate reversal byRBI and deteriorating Govt of finances

In the third quarter policy review on Jan 24th2012, the RBI cut the cash reserve ratio (CRR) by 50bps to

5.50%, while keeping the key policy interest rates unchanged. RBI had earlier indicated in its Octoberpolicy review that it is done with its tightening cycle and accordingly maintained status quo in December.It was the first rate cut since RBI started hiking in 2010. A 50 bps CRR cut is expected to release aboutRs 32,000 cr of liquidity into the system.

Liquidity had been extremely tight recently with banks borrowing to the tune of Rs 120,000 140,000 crdaily from RBI - twice the amount that RBI is comfortable with. Liquidity may remained tight inspite of RBIconducting Open Market Operation (OMO) purchases (buying Gsecs) of around Rs 72,000 cr. It waspartially due to forex intervention of RBI in recent months. Also, the upcoming state elections have

resulted in increase in currency with public. So, RBI needed to ease the structural pressure in liquidity. Atight liquidity condition, above a threshold, restricts the flow of credit to productive sector harming growthwhich is anyway slowing. Continued tight liquidity has prompted RBI to restart OMO. Another CRR cut isexpected by March 2012. Higher government expenditure, RBI steps and slower credit growth willsupport liquidity going forward.

The central bank revised downward the FY12 GDP estimate to 7% from 7.6% on slower investment,weak industrial production along with global uncertainties. Growth decelerated due to fiscal profligacycombined with monetary tightening, policy paralysis and poor confidence. Growth next fiscal will alsoremain muted.

Fixed Income Market View & Outlook

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The RBI remained worried about inflation and retained its March 2012 inflation estimate at 7% despitesignificant downward revision to growth. The recent fall in WPI to 7.47% yoy in Dec 2011 from 9.11% inNov 2011 was due to high base and sharp fall in vegetable prices. But the structural supply side issues inprotein based food items remained. Inflation is expected to moderate further to around 6.8% to 7% byMarch 2012 end. There are risks from suppressed inflation as impact of rupee depreciation is yet to befully felt. Further, if the administered fuel prices are raised after state elections, headline inflation mightnot come down to RBIs acceptable level even after March 2012. However, inflation next fiscal may bestill much lower than this fiscal on aggressive rate hikes, stabilizing global commodity prices andmoderation in economic growth.

The need for tighter fiscal policy is being talked about for some time now. Fiscal deficit in FY12 may bemuch higher, as government has already borrowed around Rs 93,000 cr more than budgeted. Fiscaldeficit till Dec2011. this fiscal has already reached 92% of budgeted estimate. There may be considerableuncertainty over the fiscal consolidation next year too without any reforms on subsidy. The centralgovernment borrowing next year may be around the same, if not a little higher, than this fiscal. One-offgain from expected 2G auction next fiscal might reduce pressure.

Fixed Income Overview

The bond yields rallied immediately after RBIs CRR cut on Jan 24th2012 and touched a low of 8.08% but

sentiment turned bearish on inflation worry and absence of OMO purchase indication in the policy

statement. 10-yr benchmark yield moved back to 8.35%. However, by end of the month, continuedliquidity tightness inspite of CRR cut, this may led to announcement of OMO purchases again.Benchmark yields eased to 8.28% as on 31

stJan 2012. The 10-yr G-sec yields had softened 28 bps since

end Dec 2011. The 10 year benchmark G-Sec was on an average 8.26%. Corporate bond yields softenedtaking cues from G-Secs, with 10 year AAA closing the month at 9.30% as against the previous monthsclose of 9.44% and 5 year AAA closed at 9.43% (Previous month: 9.48%).

In money market, the CD yields moved up during the month on tight liquidity with 3 months, 6 months and1 year CDs closed the month at 9.98%, 9.95% and 9.95% as against 9.57%, 9.65% and 9.74% at Dec2011 end.1 year Overnight Interest Swaps (OIS) and 5 year OIS were trading at 8.16 % and 7.30% atmonth end as against 7.75% and 7.10% at end of December 2011.

Fixed Income Market Outlook

In the policy, the RBI has hinted that the further policy actions will depend on trend in core inflation and

governments credible, sustainable fiscal consolidation numbers. Going forward, G-sec market may takecues from OMO auctions, policy makers statements, liquidity scenario and hi-frequency key macro-economic data points like growth, Wholesale Price Index (WPI),Index of Industrial Production (IIP), creditnumbers etc. Global developments like crude oil price, situation in Iran, Euro crisis, Central banksstatements and actions will be closely watched.

Liquidity in February might ease from previous month on Government expenditure and further OMO by

RBI. Yields on short term bonds are expected to remain range-bound.

Common Source for Fixed Income View: RBI, Bloomberg, CMIE

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