The bond market is finally seeing some light at the end of the long tunnel. Of late, it has been hit by a torrent of turbulence, namely inflation, rate hikes, tight liquidity and the ever-increasing supply of government bonds, and these factors have kept the market in a bearish mode for the past three years. The intensity of the four factors has decreased over the past six months and a couple of factors are actually turning positive for the market. Bond yields will look to trend down from the current levels of 8.20% on the 10-year benchmark government bond on the back of a positive sentiment, going forward.
Inflation as measured by the WPI (Wholesale Price Index) for August came in at 7.55% against market expectations of around 6.95%. The higher-than-expected figure negated some of the euphoria of the diesel price hike effected by the government and the yield on the 8.15% 2022 government bond rose 6 basis points (bps) from lows, post data release. Inflation expectations are still around 7-7.5% over the next couple of months, but the fact is there are no fresh drivers. The prices have been sticky at over 7% levels, largely due to slow pass-through of administered prices such as electricity and fuel to the end user.
In terms of demand and global commodity prices, inflation outlook is not negative. On the demand side, falling GDP growth, which may be revised to below 6% levels from 6.5% by the Reserve Bank of India (RBI), is a proof that demand is weakening. Global commodity prices are still down 5% on year while oil has turned around 6% weaker from the highs of last year.
The RBI is not expected to cut rates in its September 17 policy review, given the higher-than-expected inflation numbers. But there could be a surprise as the government, mindful of the need for fiscal consolidation, has finally gone the distance by raising the politically sensitive diesel prices, which were hiked by as much as Rs5 per litre, the first such upward revision in the past one year.
Liquidity conditions have eased considerably over the past six months with deficit system liquidity as measured by bids for repo in LAF (liquidity adjustment facility) auction of the RBI coming off by around Rs60,000 crore. Repo bids are averaging around Rs40,000 crore against an average of around Rs1,00,000 crore six months ago. RBI bond purchases of Rs80,000 crore, coupled with rising bank deposits and low credit growth – incremental credit-deposit ratio stood at 25% as of August 31 – are also helping ease liquidity conditions. Outlook for liquidity is more positive than negative, going forward, on the back of neutral policy, low demand for credit, rising deposit growth and positive portfolio flows – FIIs have invested over $13 billion in Indian bonds and equities in calendar year 2012 till date.
The government borrowing, at one point, was threatening to overshoot budgeted levels of Rs4,79,000 crore for 2012-13. The hike in diesel prices, coupled with limit on LPG subsidy, will help consolidate government finances even though the absolute quantum of fuel subsidy will rise from the budgeted levels of Rs43,000 crore. The government may yet borrow more but that borrowing will only be known after January 2013. The government recognises the need to keep its borrowing down as it forces the RBI to go slow on rate cuts and forces rates higher in the economy. This recognition will have a positive effect on bond markets which have been complaining about a complete lack of empathy by the government.
Corporate bond market saw yields fall on the back of easing liquidity expectations. Five-year and ten-year AAA benchmark yields fell 8bps and 4bps, respectively, week on week. Five-year and ten-year AAA credit spreads fell 8bps and 2bps on week due to a fall in corporate bond yields. Outlook for AAA credits are positive on the back of easing liquidity conditions and stable to positive sentiment on government bond yields.
OIS (Overnight Index Swap) yields fell mainly because of fuel price hikes, with those of one- and five- year OIS falling 4 bps and 3 bps week-on-week, respectively. OIS yields are likely to hover around current levels though there will be a tendency for the market to start receiving the 5-year government bond and 5-year OIS spread, which is at 100bps at present. The spread is attractive, with the sentiment on government bonds turning around.
Parthasarathy is the editor of www.investorsareidiots.com, a website for investors