There are ominous signals on the interest rate front. Bond yields rose to a two-month high last week after a surprise rise in industrial output in April 2009 from a year earlier, suggesting the economy is turning around faster and the monetary policy easing is nearing its end.

Even as the Reserve Bank of India (RBI) and the government are striving hard to transmit the cut in key policy rates to the banking system, there are strong indications that the era of soft monetary policy is coming to an end. The higher government borrowings and surplus liquidity in the system are adding to the upward pressure.

Given the outlook on inflation, policy rates may start going up in early-2010, bankers and analysts have already warned. “In the near term, although there is a small probability that the central bank may choose to err on the side of boosting demand and provide a token cut in short-term policy rates to boost investment after the elections, we think that the policy easing is done,” said Tushar Poddar and Pranjul Bhandari of Goldman Sachs.

“We think that given the long lags in the transmission between policy rates and activity, additional cuts would be a mistake as it would affect demand when it is already rising, and risk stoking inflationary pressures,” they said. The 10-year benchmark bond almost came closer to the 7 per cent level last week. It ended at 6.89 per cent, after rising to 6.94, its highest since April 8, but still rose by 33 basis points during the week. As a result, bank stocks were under pressure as any rise in yields will make a hole in the valuations of banks’ bond portfolio. “Although the RBI is close to the end of its easing cycle, yields will likely stay in the 6 per cent to 7 per cent range due to the possibility of one last cut and the RBI’s continued participation in the borrowing programme,” said Rohini Malkani, economist, Citi India.

... contd.