Of the yield curve

The yield curve inversion is becoming more visible – 3M PKRV trading at 13.71 percent while 10-Y paper is at 11.65 percent. In July, the 10Y paper was 80-85 bps higher than the 3M paper. The realization in the market is seeping that such rates are not likely to get in a few months that is why market is grabbing on the opportunity. And sudden dip in 10Y paper last week could partially explain the rally of stock market this week.

The short term rates are sticky and are moving pretty much in line with the discount rate (13.75%), and the KIBOR – determined by banks, is at similar rates. A few market pundits are questioning that why KIBOR is following the T-Bills rate and why it cannot be at 2-3 percent discount. That might not happen, as the government’s risk is usually less – and that is not a possibility in Pakistan. Some say that it is banking companies’ cartel in Pakistan that is keeping rates high – the cartel might exist, but rate fixing is a different story.

Back in days, between Dec-02 to Mar-05, the discount rate was at 7.5 percent but the treasury bills rates fell to as low as 1.2 percent in Aug -03, and remained at steep discount to discount rate. At that time KIBOR did exist, but interbank rate was trading close to T-Bill rate – much lower than discount rate. This might be in the mind of people, and the question is why it is not happening now.

First there was no interest rate corridor at that time and there was no concept of policy rate. Hence, now interest rates are to move in corridor to curb volatility, and it is by design.

The other point is the drawback of lower rates relative to discount rate. NSS used to be pegged to discount rate, and the DSC rates were 8.5 percent in Aug-03 when T-Bills (or KIBOR equivalent) was below 1.5 percent. There was a clear arbitrage opportunity and those who had access to banking loans, borrowed from banks and made a killing by investing in DSC.

Now if today, somehow KIBOR comes at 2-3 percent lower than the T-Bill or discount rate, the arbitrage opportunity may still exist and in efficient market it has to be plugged by market forces, but in Pakistan, this could be a free lunch for big boys. Back in days of 2002-05, many borrowed at lower rates, and invested in asset markets – stock and real estate, and the speculation was at its peak. Not desirable.

The question is why interest rates came down in 2002-05. The simple answer is that market was flushed with liquidity and there were lack of avenues for banks to invest – government budget deficit was too low (avg: 2.8% in FY03-05). The rates nosedived despite higher discount rate. The deficit story is not good today and may remain under stress for couple of years, at least.

However, if the market is to be flooded with liquidity (say $6 bn in hot money comes in next 12 months), the T-Bills rate and KIBOR could come down – but by not much as it would hit the corridor. And seeing that, SBP may lower policy rate – but without lowering fiscal deficit or bringing foreign liquidity or a combination of both, market rates will follow the SBP policy rate, not the other way round.