WPI inflation rose to 7.81 per cent year on year in September from 7.55 per cent in August, above market expectations. The rise was largely due to the hike in diesel prices in mid-September, which contributed about 44bp to headline inflation.

Food inflation eased to 8.5 per cent year on year in September from 9.1 per cent in August as lower fruits and vegetable prices more than offset increased prices for manufactured (processed) food items.
Core inflation remained unchanged at 5.6 per cent year on year in September.

However, worryingly, prices of all the sub components increased, with basic metals, chemicals and textile categories rising most. Elsewhere, July WPI inflation was also revised up to 7.52 per cent from 6.87 per cent following an upward revision to manufactured food and electricity prices.

We expect headline inflation to inch above 8 per cent in the coming months. The diesel price hike has not yet been fully reflected in the WPI reading, and we expect it to add another 20bp to headline inflation in October.

We believe higher transportation costs will push food inflation, particularly fruit and vegetable prices, higher in the coming months. Recent rupee appreciation should ease cost pressures, but with growth bottoming, the risk of recent input cost pressures being passed through to consumer prices cannot be ruled out.

In our view, the inflation print does not make a convincing case for the RBI to cut the repo rate. One might attribute the uptick in inflation to the diesel price hike. However, there has been an across the board increase in prices of manufactured items, and we believe price pressures are unlikely to wane anytime soon, as suggested by the 3month over three month seasonally adjusted annualized rate (a measure of sequential momentum) of core inflation.

With the risks of inflation clearly tilted to the upside, the trade deficit worsening and CPI inflation near double digits, we do not think it appropriate for the RBI to let its guard down on inflation. We expect it to cut the repo rate only in H1 2013, premised on our view of a moderation in inflation starting in December (data released in January).

That said, we see the possibility of the RBI cutting the CRR by 25bp as a positive response to the government initiating the reform process.

From the perspective of the rates market, these numbers do not provide any clarity. As one can see, headline rose (7.81 per cent year-on-year, previous 7.55 per cent year on year) while core was flat (5.6 per cent year on year, previous 5.6 per cent year on year).

In the end, it remains a judgment call by the RBI. Based on these numbers, we think the market will continue to trade in the current range. As such, our economics team does not expect a repo rate cut and overall, we assign only 25-30 per cent probability to a repo rate cut.

We continue to have long/receive bias in rates. However, as noted earlier, from the perspective of positioning and levels, we believe participants should express this view through sovereign bond markets.

We expect bonds to benefit from reduced issuance in the second half of the fiscal year (year ending March 2013), substantial demand for bonds from the banking system in a low credit growth environment and our expectation for open market operations in the second half of the fiscal year. In (ND)OIS, we recommend waiting for better levels to initiate outright receives in 3 to 5 years (ND)OIS.