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Government bond yields will rise further from current levels on worries of liquidity and supply. The ten-year benchmark, the 8.79% 2021 bond, is trading around 8.35% and yields on it will rise to around 8.60% in the coming weeks, on lower demand in the auctions.

The 50 bps Cash Reserve Ratio (CRR) cut on January 24 had a negative effect on bond yields. For instance, yields on the 8.79% 2021 bond rose 20 bps from lows post-policy.

Markets did not take the CRR cut well on three counts. One, the CRR, while adding Rs32,000 crore to the system, will not bring down the system liquidity to levels where the market will be comfortable. Two, the RBI contradicted itself by cutting the CRR, as it said it was a liquidity measure and not a policy stance. Three, the RBI has discontinued bond purchases through Open Market Operations (OMOs), leading to worries on government bond supply absorption in the face of tight liquidity conditions.

System liquidity as measured by the bids for repo in the Liquidity Adjustment Facility (LAF) auction of the RBI is not showing any signs of easing. Bids for repo on January 27 were over Rs1.5 lakh crore with the daily average for last week around Rs1.4 lakh crore. Daily average bids for repo in the week of January 9-13 was at Rs1.52 lakh crore.

The CRR cut will bring liquidity down to just around Rs1 lakh crore; but, if the RBI continues to intervene in the currency markets, liquidity will tighten further.

Tight liquidity conditions towards the end of the fiscal year will make the system hoard liquidity, leading to further tightness. The RBI will have to cut the CRR again in March to ease liquidity.

The RBI was saying all along that the CRR is a monetary tool and that was the reason they embarked on a government bond-buying programme in November 2011, to ease liquidity rather than cutting the CRR to ease liquidity. The RBI at that time felt a CRR cut would send wrong signals of policy easing by the central bank.

The RBI, however, is now saying that it cut the CRR to ease liquidity and it is not to be taken as a monetary easing stance. The repo is the monetary policy rate now. The changing stance of the RBI confused the market and given that bond yields were trading at over seven-month lows, the market chose to sell bonds due to a confused state of mind.

By cutting the CRR, the RBI has discontinued the purchase of government bonds through OMO. The market was fine to bid bonds in auctions at lower levels of yields as it found a buyer in the RBI for taking out excess supply. But with the RBI absent now due to the absence of OMOs, the market is facing withdrawal symptoms. The RBI has stated that it will use OMOs if necessary, but that necessity will come when auction demand wanes, leading to bond yields trending higher.

The interest rate swap curve moved up in sympathy with rise in government bond yields.

The five-year Overnight Index Swaps (OIS) yields moved higher by 7 bps and one-year OIS yields moved higher by 13 bps week-on-week. The rise in one-year OIS levels suggests that liquidity conditions will worsen in the coming days.

Credit spreads fell as corporate bond yields did not rise in tandem with government bond yields. Five- and ten-year AAA benchmark credit spreads fell by 20 bps and 18 bps week-on-week to close at 80 bps and 75 bps levels respectively. Credit spreads will stay down as corporate bond yields remain sticky even as government bond yields rise on supply and liquidity fears.

Government bond auctions
The government auctioned Rs13,000 crore of bonds last week. The bonds auctioned were the 8.19% 2020 for Rs4,000 crore, the 9.15% 2024 bond for Rs6,000 crore and the 8.97% 2030 bond for Rs3,000 crore. The cut-offs came in at 8.37%, 8.45% and 8.66% respectively. The government is scheduled to auction Rs13,000 crore of bonds this week.

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