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Market is expecting another 200-300 bps rate cut in next 6-9 months based on the participation in the T-Bills auction earlier this week. The cut off yields are down by 40 bps to 10.9 percent (3M) to 160 bps to 9.65 percent (12M). Government fetched Rs434 billion (against target of Rs500bn) while the participation was Rs1.9 trillion (against the maturity of Rs235 billion).

The higher participation was not just in the auction; but there were signs of yields coming down earlier this week as well. This implies there is higher demand of papers which is bringing the price down. There is no foreign portfolio investment expected at this point due to global shift. Locals are driving up the demand.

There are anecdotal evidences that companies are investing in money market mutual funds and these are buying government papers from the market and in auctions. One reason could be that big companies have cash surpluses which were supposed to be deployed in their respective businesses. But not in lockdown. Hence the flows have been diverted towards fixed income instruments.

Banks at the same time are reluctant to offer fresh loans. The risk of banks’ balance sheets is increasing due to deferment of loan principal payments. NPLs may rise and they will be delayed with a systematic impact on the balance sheets. Banks may not want to expose more to private sector and are deploying liquidity in government bonds.

Another reason for higher participation is that market is expecting inflation to come down at a pace faster than earlier expectation. With fall in inflation, interest rates are expected to come down faster. Investors are trying to get bigger positions in the government papers before the yields come down further.

The 3-year paper is trading at 8.94 percent and the yield curve is still inverted up till 3 -year paper. From 10.99 percent on 1 Week to 8.94 percent in 3 years. But beyond three years, it is flat till 10-year. The trajectory of yield curve is similar (beyond 6 M paper) as it was prior to COVID but rates across the tenures are down by 2.2-2.7 percent.

Some are expecting an interest rate cut in an emergency meeting prior to one scheduled in May. However, there are no signs based on inflation and currency movement. Any sudden decline in rates (which may result in negative real rates) could exert pressure on PKR. Otherwise based on REER and current account, PKR/USD may appreciate to 155-160. But precarious financial and capital account position amid thinning SBP reserves may keep currency in band of 160-165 till the next MPS decision.