Kumaresh Ramakrishnan is an engineer from K J Somaiya College of Engineering, Mumbai. He did his MBA from Narsee Monjee Institute of Management Studies and has over 16 years of experience in the Indian Fixed Income market. At present, he is working at Deutsche Asset Management (India) Pvt. Ltd as Head - Fixed Income.

The yield curve is now inverted with rates highest at the short end, which was intended through the recent actions. RBI has conveyed to the market its readiness to act, which is likely to keep a check on excess volatility.

3 month and 9 month March CDs are now trading 375 bps and 300 bps over the policy repo rate of 7.25%. These levels are even higher than the levels witnessed in March 2012, when liquidity tightness was at its peak.

Money market liquidity has reduced considerably, following the pruning of banks access of the LAF window. Besides, issuance of short term T bills has also soaked up liquidity from the system. Low levels of liquidity prevailing in the system, is now reflected in the higher short term rates and the inverted yield curve.

2. Could you please share the dynamics of the cyclical liquidity nature of Indian debt markets? How can investors benefit from this?

Liquidity scenario in the Indian context has been negative for over three years now, starting with the 3G auctions in June 2010. Within the negative zone, absolute levels have varied depending on seasonal needs from banks and corporate.

What started off as a short term phenomenon (post the sudden demand for funds after the 3G auction) has continued, as inflation commenced its upward trajectory from 2010. RBI's sustained rate action since then has helped to combat inflation which has started reversing in the last few months.

High and stubborn (WPI and CPI) inflation forced RBI to maintain a tight liquidity regime for an unusually long period. In the process, growth was also impacted as banks continually raised their base rates to align with rising policy rates.

In the last two years, dollar liquidity has also remained very low, as reflected in the almost unchanged forex reserves position of RBI. Higher inflation also led to a de-channeling of financial savings to physical assets such as gold and real-estate investments. All of this impacted M3 growth in the economy. Part of this loss of liquidity was compensated through an expansion of RBI’s balance sheet by way of OMO purchase of bonds by RBI which were carried out to provide liquidity to market.

For liquidity to revert to normative levels, inflation falling to trend levels is a pre-requisite. This will reduce the relative attractiveness and motivation of potential investors to divert money to non-financial assets.

While RBI commenced its rate cutting cycle in April 2012 with a 50 bps cut, the journey so far has been chequered and in an uneven fashion, as intermittent events have influenced the pace of rate reductions.

Investors can take advantage of the cyclical nature by investing in line with their risk appetite as also choosing the products which are best positioned to benefit from the rate cycle.

For instance, at present post the sudden turn of events of the last two weeks, the short and mid end of the curve has moved up quite significantly (by almost 100-150 bps). In our view, these yield levels are not sustainable beyond the short term as the economy eventually needs lower rates to address growth risks, once the currency volatility is under control.

Investors in the present juncture can hence choose from Short Maturity Funds and their variants as also Medium term bond funds.

3. In the absence of rate cut expectations, what are the directional cues on which bond traders will focus on in the medium term?

Factors such as currency volatility and probability of follow-up RBI action on liquidity are likely to influence short term direction of rates. We believe that the probability of increase in repo rates is low, since RBI has adopted liquidity tools to convey status-quo on its rate messaging to the market.

4. What is your outlook on interest rates? How will they affect returns of debt funds over the next one year?

In our view, ability of banks to cut rates could get deferred post these moves. Eventually though, lower rates would be needed in complementing other factors needed for a recovery. We expect rates to trend down once the recent measures work fully through the system and currency volatility abates. Even in the absence of policy rate cuts, we expect yields to soften as it is worth noting that banks had anyways only passed on a portion of the policy cuts to their end consumers.

Domestic macro viz. low IIP, soft GDP and falling inflation are all supportive of lower rates. Falling yields are expected to re-exert a pressure on banks to start lowering their lending rates.

We expect debt funds in general to be able to return higher than their coupons over the next 12 months. Our expectation is for yields to lower gradually from current levels. This will lead to some capital gains which will add to the existing coupons and generate returns which are higher.

5. What is your advice to investors in the current market scenario and what kind of products do you recommend to investors who are looking at fixed income products right now?

The recent measures while having caused short term dislocations to the curve have also made bonds attractive again. Effectively, medium term bond yields (3, 5 years) are now even higher than the levels witnessed at the start of the rate easing cycle in March 2012. This has made re-entry into the short and medium term bonds very attractive.

At the present juncture, Short and Medium term funds in our view are best positioned to capitalize from the upmove in yields. ‘Carry’ has turned highly attractive all over again and in our view more than negates the short term volatility. Flattish nature of the curve continues to support our view that risk-reward is at the short / medium segment of the curve.

Investment tenors (3-6 months) in short / medium term funds would in our view be consistent with the time needed for a normalization of liquidity and rate conditions.