Fuel fiasco a big letdown for markets

The bond market was looking forward to a diesel price hike that would have killed two birds with one stone. It would have allayed fears of a higher-than-budgeted government borrowing for the second half of 2012-13 and let the Reserve Bank of India (RBI) ease its hawkish stance over the government’s perceived inaction of any credible fiscal consolidation. There were strong rumours of a price hike that was supposed to take place last week, but the oil minister has set the record straight, categorically ruling out any such revision in the immediate future.

The markets expressed their disappointment by pushing up bond yields by 4 bps from the lows of the last week. The 10-year benchmark, the 8.15% 2022 bond closed last week at 8.20% levels, from of 8.16% seen during the week. So, fingers are crossed on interest rate cuts as the mid-quarter policy review by the Reserve Bank of India (RBI) on September 17 approaches.

The RBI has many reasons to ease rates, given that GDP growth is expected to fall sharply from estimated levels of 6.5%, mainly because of lack of credit offtake and below-par monsoons. Incremental Credit Deposit Ratio (ICDR) for 2012-13 till date is just 9.5%, indicating a sluggishness in credit growth. Monsoons have been below normal this year despite some recovery in August and September, which in all likelihood will drag down agriculture growth and pressure GDP. Amid all these signs, however, the government is showing no signs of improving its fiscal condition by reducing the fuel subsidy burden, which is expected to go up by at least three times from the budgeted subsidy of Rs43,000 crore. The bill has, in fact, already touched 75% of the budgeted fuel subsidy in the first quarter of 2012-13. For the central bank, absence of a price revision is yet another sign of poor fiscal policy, which may force the bank to reconsider the pace of rate cuts despite chances of growth falling off the cliff.

Bond markets have two positives going for them at present. One is the easing system liquidity and the other, the appetite of banks for government bonds. Liquidity as measured by the bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI saw bids for repo averaging Rs14,300 crore on a daily average basis against bids of Rs47,800 crore seen in the week previous to last. Liquidity will tighten as advance tax payments go out of the system in mid-September, but the tightness will be temporary, as the money will flow back into the system in the form of government spending. Liquidity is helped by a weak ICDR as banks are left with surplus liquidity due to weak credit growth. Banks are using the excess liquidity to purchase government bonds – banks have bought government bonds worth over Rs1,80,000 crore in 2012-13 to date – and this appetite is helping 10-year government bond yields stay at around 8.20% levels despite worries of a higher supply, going forward.

Money market securities yields are dropping in the face of easing liquidity pressures. One-year CD (certificate of deposit) yields have dropped by 70 bps from highs in April 2012 and are currently trading at around 9% levels. Banks could bring down deposit rates further as weak credit growth forces them to focus on margins. And lower deposit rates would pull down CD yields.

Corporate bonds will benefit from easing liquidity conditions, but this will be restricted to only the top rated borrowers. Benchmark AAA ten-year corporate bond yields at 9.25% levels will look to come off on demand for higher yields from investors.

The OIS (Overnight Index Swaps) yield curve lost its inversion by 7bps last week on the back of easing liquidity conditions. One-year OIS yield came off by 3bps while that of the five-year OIS rose by 4bps on week and the five over one OIS spread closed at a negative 56bps last week. The OIS yield curve has been inverted for almost a year and half and this inversion may come off on easing liquidity conditions.

Government bond auctions
The government auctioned Rs16,000 crore of bonds last week, which included the 8.07% 2017 bond for Rs4,000 crore, 8.15% 2022 (Rs 7,000 crore), 8.97% 2030 (Rs3,000 crore) and 8.33% 2036 (Rs2,000 crore). The cut-offs came in at 8.21%, 8.19%, 8.58% and 8.54%, respectively. There is no government bond auction scheduled for this week. 

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