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The Reserve Bank of India (RBI) stoked a bond rally by announcing bond purchase auctions to infuse liquidity into the market. Bond yields fell 20bps due to RBI’s purchases. The ten-year benchmark, the 8.79% 2021 bond, closed last week at an eight-month low of 8.15%. Bond yields had earlier threatened to go higher as the market felt the RBI had discontinued OMOs (Open Market Operations) after the recent CRR (Cash Reserve Ratio) cut. The yield on the 8.79% 2021 bond had gone up by 20 bps after the CRR cut when the RBI discontinued OMOs for a week.

The RBI has stated that it will continue using OMOs to boost liquidity. System liquidity as measured by bids of repo in the LAF (Liquidity Adjustment Facility) of the RBI, averaged Rs125,000 crore on a daily basis last week, lower thanthe Rs1.42 lakh crore the previous week.Infusion of Rs32,000 crore from the 50 bps CRR cut helped lower bids for repo. The RBI will continue to buy bonds through OMOs ifliquidity stays over Rs1 lakh crore.

The markets’ dependence on OMOs shows that yields at lower levels cannot hold if the RBI does not buy bonds. Bond yields have rallied by 75 bps over the last three months on the back of RBI bond-buying, rate cuts and expectations of more rate cuts. The government is scheduled to auction Rs36,000 crore of bonds over the next three weeks, and market bids at the auction will depend on whether the RBI would conduct bond purchase auctions. If the RBI does not conduct OMOs, markets will bid at higher levels of yields at the government auctions, lifting yields off lows.

The US jobless rate fell to a three-year low of 8.3%. And the rise in new jobs will prey on the market’s mind when trading starts this week. The US economy added 2.43 lakh jobs in January 2012, higher than the expected 1.4 lakh jobs – something that lifted the US benchmark ten-year treasury yields 9 bps. The US Federal Reserve had indicated that it will keep rates at all-time lows till late 2014, but if economic data improve, markets will factor in earlier-than-expected rate hikes, lifting treasury yields.

The interest rates swap curve, too, is likely to steepen. Five-year OIS (Overnight Index Swaps) yields will rise from 7.24% while one-year OIS yields will fall from 8.04%,leading to the inverted curve flattening and then starting to steepen down the line.

Ten-year corporate bonds yields fell 10 bps week-on-week due to a rally in government bond yields. Credit spreads as measured by the difference between ten-year government bond yields and ten-year AAA corporate bond yields rose by 11 bps week-on-week as government bond yields fell faster than corporate bond yields. Credit spreads will rise if the RBI continues OMOs but will fall if the RBI discontinues OMOs (in which case government bond yields will rise sharply as well while corporate bond yields will remain sticky leading to rise in credit spreads).

Government bond auctions
The government auctioned Rs13,000 crore of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs3,000 crore, the 8.79% 2021 bond for Rs7,000 crore, and the 8.83% 2041 bond for Rs3,000 crore. The cut-offs came in at 8.18%, 8.15% and 8.55% respectively. The government is scheduled to auction Rs12,000 crore of bonds this week. The RBI bought bonds worth Rs8,819 crore last week. The RBI bought the on-the-run bond the 9.15% 2024 bond for Rs5,900 crore at 8.23%, leading the market to believe that it will buy the 8.79% 2021 bond should it conduct a bond purchase auction this week. That the RBI is buying on-the-run bonds is a bullish sign for the market as it shows that the central bank is willing to buy bonds at market levels to infuse liquidity into the system.

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