Column

The inflation numbers for December 2011 to be released today will likely help sustain the bond rally of the last one-and-a-half months. Inflation as measured by the Wholesale Price Index (WPI) is widely expected to come in at below 7.5% for December 2011, the lowest level in two years.

Such expectations, however, have been driven down by a sharp fall in primary article inflation, which printed at 0.51% for the week ended December 13. Primary article inflation has fallen from 6.9% at November-end largely due to fall in food price inflation from 6.6% to a negative 2.9% over one month.

Government bond yields have seen a healthy fall over the last one-and-a-half months, with the 10-year benchmark bond yield falling over 50 bps. The benchmark 10-year bond, the 8.79% 2021 bond, is trading at 8.19%, which is the lowest level seen since the time it was issued in November 2011. The yield on the bond can fall another 10-15 bps due to falling inflation expectations.

The latest Open Market Operation (OMO) auction showed a distinctly bullish sign for the markets. The Rs12,000-crore bond purchase auction of the RBI held on January 13 saw the market tendering the most bids for the 7.83% 2018 bond while the 7.80% 2021 bond saw the least bids tendered. The market bid to sell the RBI Rs10,881 crore of 7.83% 2021 bond while the central bank bid only Rs1,500 crore for the 7.80% 2020 bond.

The RBI accepted bids worth Rs8,758 crore of the 7.83% 2018 bond and Rs300 crore of the 7.80% 2021 bond. The fact that the market did not want to tender the 7.80% 2021 bond in the purchase auctions shows the market’s lack of appetite to sell the bond even at lower levels of yields. (Yields have come off by 50bps on the 7.80% 2021 bond over the last one-and-a-half months.)

Lack of market interest in tendering stocks for the OMO will likely force the RBI to cut the Cash Reserve Ratio (CRR) to add liquidity to the system. System liquidity as measured by the bids for repo in the Liquidity Adjustment Facility (LAF) auction of the RBI tightened by Rs32,000 crore last week. Bids for repo at 8.5% in the LAF averaged Rs128,000 crore on a daily basis last week, against an average of Rs96,000 crore seen in the week before last. Liquidity conditions are showing no signs of easing despite the RBI buying almost Rs53,000 crore of bonds over the last 45 days.

Corporate bond yield curve inverted with the shorter end of the curve is trading at higher yields than the longer end of the curve. Tight liquidity conditions are keeping yields on the shorter end of the curve high. The fact that foreign institutional investors (FIIs) cannot automatically roll over limits on bonds sold or matured is clouding sentiment on short maturity corporate bonds.

The swap curve moved higher on the back of tight liquidity conditions. One-year overnight index swap (OIS) yields moved up by 14 bps week-on-week to close at 7.86%. Five-year OIS yields moved up by 3 bps week-on-week to close at 7.12%. OIS curve will continue to underperform government bond yields, given the steep negative spread between swap yields and government bond yields.

Government bond auctions
The government auctioned Rs14,000 crore of bonds last week. The bonds auctioned were a new eight-year bond for Rs4,000 crore, the 9.15% 2024 bond for Rs6,000 crore, and the 8.97% 2030 bond for Rs4,000 crore. The cut-offs came in at 8.19%, 8.36% and 8.54%, respectively.

The government is auctioning Rs14,000 crore of bonds this week.

The RBI bought Rs11,760 crore of bonds through OMO purchase auctions last week. The bonds bought were the 7.83% 2018 paper for Rs8,758 crore at a yield of 8.22%, the 7.80% 2021 bond for Rs300 crore (8.30%), the 8.13% 2022 bond for Rs1,806 crore (8.33%) and the 8.28% 2032 bond for Rs895 crore (8.51%).

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