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Government bond yields fell sharply week on week (w-o-w) due to expectations of rate cuts by the Reserve Bank of India (RBI).

The bond market shrugged off higher supply and took down benchmark yields by 30-35 basis points (bps). The market is factoring in RBI absorbing most of the excess supply of Rs40,000 crore through open market operations (OMOs).

Yield on the ten-year benchmark, the 8.79% 2021 bond, fell 36 bps w-o-w to close last week at 8.22%. Yield on the well-traded 9.15% 2024 bond fell 36 bps to close the last week at 8.35%. The yields on these two bonds have come off by 70 bps and 80 bps, respectively from highs seen in the last couple of months.

The market has a lot of positives going for it at the moment. The RBI has indicated that rate cuts are imminent, given that inflation fears have eased and growth concerns have increased. Tight liquidity conditions have given hopes of cash reserve ratio (CRR) cuts.

The RBI is buying bonds at market levels to infuse liquidity into the system. The markets view the fall in food inflation as highly positive as it will lead to a fall in overall inflation as well. Given these positives, the market will keep bond yields bid, as no trader will want to be left out of the market when a rate cut happens.

The RBI third quarter policy is scheduled for January 24, 2012. As rate cut expectations will intensify in the run-up to the policy, the market will trade with a positive bias. Weak Index of Industrial Production (IIP) growth numbers for November 2011 and a fall in the Wholesale Price Index (WPI) for December 2011 will help maintain the bullishness in bonds.

The IIP growth for October 2011 came in at a -5.1% while inflation for the month of November stood at 9.13%.

Primary article inflation for the week ended December 24, 2011 stood at 0.10%, while food inflation was -3.36%. Primary article inflation is at multi-year lows, and is driving down inflation expectations.

Liquidity as measured by bids for repo in the Liquidity Adjustment Facility (LAF) auction of the RBI eased last week. Bids for repo averaged Rs96,000 crore on a daily basis last week, against an average of Rs1,23,000 crore the previous week. Interest of around Rs10,000 crore paid on Special Deposit Scheme (SDS), coupled with RBI bond purchases and government spending at the beginning of the month eased system liquidity. Liquidity will remain negative but will not return to extreme negative levels seen in December 2011.

The swap market stayed flat in spite of the rally in the government bond market. One-year Overnight Index Swap (OIS) yields were unchanged at 7.72% levels; and five-year OIS yields fell by one basis point to close at 7.09%.

The spread between the ten-year government bond yield and the five-year OIS yield at 113 bps is keeping OIS yields from falling.

Credit spreads rose as corporate bond yields fell less than government bond yields. Five- and ten-year benchmark AAA spreads rose by 17 bps and 24 bps respectively week-on-week. Five-year credit spreads closed at 94 bps while ten-year credit spreads closed at 93 bps. Credit spreads will remain pressured due to tight liquidity conditions and government bond supply.

Government bond auctions
The government auctioned Rs14,000 crore of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs4,000 crore, the 8.79% 2021 bond for Rs7,000 crore and the 8.28% 2032 bond for Rs3,000 crore. The cut-offs came in at 8.34%, 8.33% and 8.66% respectively. The government is auctioning Rs14,000 crore of bonds this week.

The RBI bought Rs8,472 crore of bonds through OMO purchase auctions last week. The bonds bought were the 8.07% 2017 bond for Rs1,346 crore at a yield of 8.28%, the 7.80% 2021 bond for Rs3,300 crore at 8.36% and the 8.13% 2022 bond for Rs3,825 crore at 8.36%.

The writer is editor, ww.investorsareidiots.com, a website for investors