Lead bond market indicators point towards RBI rate cut

Market participants witnessed yet another week that bode well for risk assets in an environment that appears to support economic expansion in a low-yield and liquidity glut backdrop.

The much anticipated Yellen's testimony on monetary policy before the House Financial Services Committee was a disappointment for the hawks as she clawed back her aggressive guidance and concluded by indicating that Federal Reserve may change its course if necessary. However the balance sheet unwind appears to be on course. On analysis one could glean that the Fed's objective is to engineer a slow and predictable decline in its securities holdings without disrupting financial markets.

Broader markets continued to show resilience with equities posting solid gains and Treasuries and Bonds rallying post the Fed testimony. While crude prices inched up marginally the widely followed volatility index (VIX) dropped sub 10 from 11.76 previous week.

In a week when Sensex tested 32000 for the first time ever and also posted largest weekly gain after March, bond markets started with a sharp sell-off in reaction to the OMO Sale announcement the previous week-end. However, value buying emerged at higher yield levels and bonds recovered almost all of the single day losses. The moot point however remained that demand for bonds even in an OMO was pretty strong with bids for over Rs 60,000 crore tendered against the auction amount of Rs 10,000 crore. The cut-offs in both the OMO and the weekly auction came as per market expectations and bonds closed the week steady.

Inflation readings (both CPI and WPI) came below market expectations which fueled further hopes for a rate cut in the August MPC meeting. A near historical-low print of 1.54% in the Retail Inflation, a level not seen after 1999, with core inflation coming just a tad above 4% begs the question if a larger than 25 basis rate cut would be warranted. However, one needs to moderate the expectations as this low-print is largely on account of base effect. Even July numbers are expected to be benign. Although headline inflation is below the +/-2% around the targeted 4% inflation, there is a high probability that this can be considered as transient and RBI could choose to wait.

WPI numbers also came in sharply lower at 0.90%, reiterating the deflationary environment. IIP data shocked to the downside with a reading of 1.7% against 8% same month last year led by a poor showing by both manufacturing and mining sectors. Trade data however showed a widening deficit with June deficit standing at $12.96 billion as against $.8.12 billion in June 2016. Sharp rise in imports, chiefly gold, may be seen as reasons.

Overall, the lead indicators point to possibility of rate cut and a pricing-in rally to continue. The 10-year benchmark yield at 6.47% may not be a safe bet. SDL spreads at 70 basis over sovereigns and top rated corporate bonds may be the toast. With OIS running ahead on the hope curve, another interesting week lies ahead. A test of 6.55% is still preferred in the benchmark yield.

The writer is executive director, Lakshmi Vilas Bank