Bullish auction cut-offs to calm govt bond yields

The Rs13,000-crore government bond auction held on Friday, October 19, saw strong bidding, leading to cut-offs coming in better than expected. The last auction before the monetary policy review by the RBI on October 30, the platform was used by traders to build positions on rate cut expectations. It received bids worth more than 3.4 times the auction size, indicating heavy demand for these bonds.

The ones auctioned were the 8.19% 2020 bond for Rs3,000 crore, 8.20% 2025 (`7,000 crore) and 8.83% 2041 (Rs3,000 crore). The cut-offs came in at week’s low yields of 8.16%, 8.19% and 8.35%, respectively. The strong cut-offs drove down the 10-year benchmark yield to levels last seen in July, which closed the week at 8.13%, down 4bps on week.

Shortened by holidays, there are three trading days left for the last trading week before the policy review comes up. The market is likely to stay bullish until then and there will be more demand for bonds from those who have not positioned for any rate cut. The yield on the 8.15% 2022 paper will trend down lower as demand outstrips supply in the run-up to the policy.

The RBI is likely to cut the key policy repo rate, currently at 8%, in its policy review. (Please refer to October 15, 2012 DNA Money –  Rate cut bets take root). The market, at this point of time, is factoring in a 25bps reduction. The expectations would have been higher had inflation for September come in lower, which printed at 7.81%, up from 7.55% in August. The September figure is also the highest for 2012 till date, which went up due to the recent fuel price hike.

The swap curve is factoring in repo rate cuts, with 5-year and 1-year OIS (overnight index swaps) yields closing down 4bps and 3bps on week, respectively. Those for 5-year and 1-year stood at 6.98% and 7.60%, respectively, making the curve inverted by 62bps. One-year OIS yields are held up by deficit liquidity conditions, forcing the market to borrow from the RBI at the repo rate of 8% on a daily basis. Five-year OIS yields are expecting a sharp slowdown in the economy, leading to more rate cuts down the line.

Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI tightened last week, with bids for repo averaging Rs87,000 crore on a daily basis against an average of Rs61,000 crore seen in the week before last. The source of liquidity tightening is difficult to pinpoint, as there has not been any extraordinary rise in credit growth or even currency in circulation over the past few months. Credit and deposit growth in absolute terms have almost matched out since August-end while money in circulation has fallen in August-October. One reason for rising deficit could be the maturing of outstanding forward currency sale contracts of the RBI, which stood at over $12 billion as of August 2012. The details of timing of this forward contract maturity are not published and it is only a guess that it has affected liquidity.

Corporate bond yields closed almost flat on week as markets digested low credit spreads of around 60bps in the 5- and 10-year AAA bonds. Two-year AAA bond yields fell on the back of curve corrections. Corporate bonds yields will stay steady at current levels of 8.55%, 8.70%, 8.85% and 8.90% in the 1-, 2-, 5- and 10-year AAA bonds.

Parthasarathy is the editor of www.investorsareidiots.com, a website for investors