Watch out! A mean reversion is likely on the rate front

In spite of all the noise about inflation and rate hardening for the common people, especially the retired, fixed deposit (FD) rate, which is effectively the income earned on the deposits, is still low and not showing any signs of activity.

Historically, bank FDs have given higher returns than G-Secs, by about 50-100 basis points.

The spread between SBI FD and the G-Sec yield, which was 300 bps in 2011, has now become minus 150 bps; effectively, the movement in spread was 450 bps over the last decade.

Low interest rates for bank FD have been the norm for the last few years because banks have fewer avenues to lend. These financial institutions borrow from people like you and me and lend to companies and other seekers of capital. If they cannot lend, then they have no incentive to borrow.

Corporations are not borrowing because they are still digesting the past excesses. They are using cash flows to repay debt. Capex plans are still on the drawing board. This has led to tepid credit growth. High quality borrowers are able to borrow from other sources as well.

The government is borrowing to fund the deficit and other programmes, and they are willing to pay a higher rate.

Credit growth will come back over next two years as capex plans gradually materialise. Big capex spenders are commodity companies and they are seeing benefits of inflation.

I expect this trend will change over the next two years. SBI FD will return to its long-term spread of 50-100 bps. Hence, expect that to go to the 8% range.

If you are a debt investor, invest in short-term papers and do not lock into 10-year FDs. You will feel the pinch after two years.

Equity investors, especially smallcap investors, Twitter pundits and WhatsApp fund managers should be very careful. In 2009, when SBI offered 9.5% for its 1-year FD and 10-year yield was at 5.2%, Indian mid and smallcaps were at their lowest level, even after factoring in for the global financial crisis. Since then, the mid and smallcap indices have posted 8X returns and the spread has turned inverse: bank FD at 5% and 10-year G-Sec yield at 7%. If my prognosis of the mean reversion materialises, then the smallcap and midcap space will become very challenging, to say the least.