Bond rally will gather steam

Bond yields fell by around 5 bps last week on the back of a sharp fall in 5-year Overnight Index Swaps (OIS) yields, which dropped 21 bps on week to close at 6.97% levels, the lowest close since September 2011. The rally in 5-year OIS yields is mainly due to record low borrowing costs across markets globally. Yields from Germany to Japan closed at all time lows last week on worries of economic growth. US 10-year treasury yields were down 6 bps on a weekly basis to close near all-time lows at 1.49%. The OIS markets track global bond and interest rate swap markets closely as the OIS curve is extremely active in overseas markets.

Hedge fund managers and proprietary traders in banks based outside India use the OIS yield curve for positioning in Indian interest rates and the falling numbers suggest that their outlook on Indian rates is positive. Global fund manager views on rates are largely determined by both global and domestic factors. Globally, the rally in yields suggests that growth and inflation will stay down long enough for central banks to keep rates at record lows and keep pumping in liquidity to markets.

On the domestic front, India is definitely facing a slowdown as seen by weak IIP (Index of Industrial Production) trends with IIP growth for May at 2.4% levels against a revised negative growth of -0.9% for April and against 6.2% seen in May last year. The fall in exports and imports in June by 5.5% and 13.5% on year reinforces the economic slowdown in India. Inflation is the only factor that is clouding expectations of interest rates coming off as the WPI (Wholesale Price Index) is staying sticky at 7.5% levels. However, if general inflation is stripped of food and fuel prices, the core inflation is below 5%.

The OIS market is front running RBI rate cuts, though expectations of rate cuts in the July 2012 policy are low. The market is betting on the fact that RBI will cut rates and the timing of rate cuts is not seen as important.

Inflation for June is expected to come in at over 7.5% levels. If inflation prints at significantly below 7.5% levels, yields will rally sharply as rate cut expectations in July will increase.

Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI eased last week, averaging Rs41,000 crore on a daily basis against an average of Rs43,000 crore seen in the week before last. Liquidity outlook is benign as the factors driving liquidity, including credit growth, trade deficit and government balances are positive. Credit growth at 16.5% year on year in June is down from 18.7% seen in April. Trade deficit slipped 23% month on month as of June. The government is running an overdraft of around Rs6,200 crore with the RBI indicating spending

Government bond auctions and OMOs
The government auctioned Rs16,000 crore of bonds last week. These are the 8.07% 2017 bond for Rs4000 crore, 8.15% 2022 (Rs6,000 crore), 8.97% 2030 (Rs3,000 crore) and 8.33% 2036 (Rs3,000 crore). The auction was well received by the market with the bid to cover ratio at 2.8 times, higher than the average of just over two times seen over the last few months. The cut -offs came in at 8.01%, 8.10%, 8.50% and 8.59%, respectively. The government is scheduled to auction Rs15,000 crore of bonds this week.

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