Bond market is gearing up for a post-event rally

The market is going into the policy (RBI annual monetary policy for fiscal 2011-12) expecting the worst. Ten-year benchmark bond yields are trading at a calendar year highs of 8.13%, up 7 basis points (bps) week-on-week and 33 bps month-to-date.
The market is expecting the RBI to raise benchmark repo and reverse repo rates by 50 bps each in their policy meet on the
May 3.

The fact that the government bond market is going short into the policy is a good sign as the market will look to cover the shorts once the event is over. The market will get enough opportunity to cover shorts and build fresh longs as May is heavy with bond auctions. The government is scheduled to auction Rs48,000 crore bonds in May as against Rs36,000 crore bonds in April.

The market is not as bearish as it looks. The rise in 10-year bond yields is due to the fact that the auction cut off at 7.80% for the 2021 bond was too aggressive. The government issued a fresh benchmark 10-year bond in the first week of April and the market had bid aggressively for the bond, taking down the cut off yield to 7.80%, which was at least 6 bps below expectations.

Once the cut off came in, the successful bidders realised that they were holding the bond at too aggressive levels and fell over themselves to lighten auction positions.

The March inflation number (inflation as measured by the wholesale price index came in at 8.98% against market expectation of 8.4%) further added to the selling pressure on the 10-year bond.

Expectations of fuel price hike, with Brent crude trading at close to two-and-half year highs of $125/bbl, prompted the market to go incrementally short on the 10-year bond leading to the bond yield rising by 33 bps from auction cut off levels of 7.80%.

The 7.83% 2018 bond, which was freshly auctioned along with the 7.80% 2021 bond, has also borne the brunt of the markets’ selling with its yield going up by 36 bps since the auction. The sharp rise in benchmark bond yields has skewed the yield curve with 10-year benchmark bond yields trading below seven and five year benchmark bond yields.

The curve has, however, flattened at the longer end with ten over eleven spreads compressing from 25 bps to 17 bps over the month and the ten over sixteen spreads compressing from 53 bps to 36 bps over the month. The compression at the longer end of the curve suggests that the broad market is not as bearish at the 10-year bond yield suggests.

Swap spreads too have compressed with five over one OIS (overnight index swaps) spreads compressing by 17 bps from 57 bps to 40 bps over the month. The swap curve is expecting a 50 bps hike in rates which is reflected at the short end of the curve while the longer end is looking to cover paid positions once the event is over. Credit spreads have come off with five and 10 year AAA spreads coming off by 20 bps and 17 bps over the month.

Foreign institutional investors (FIIs) are fully invested in bonds with limits of $10 billion on government bonds fully utilised and limits of $15billion on corporate bonds fully utilised. The only limits not utilised are the limits of $25 billion on infrastructure bonds and that too is due to the lack of good infrastructure bonds for investment. FIIs being fully invested in bonds signal their positive currency view as not all FIIs positions are fully hedged.
Liquidity is comfortable in the system due to government spending. The government has drawn Rs48,000 crore overdraft from the RBI as on April 22.

The RBI in turn is issuing cash management bills and increasing the Treasury bill auction size to bring down the overdraft to the overdraft limits of `45,000 crore. Overnight rates will trade at repo rates as the market is arbitraging repo rate of 6.75% against money market paper yields of over 8%.

www.arjunparthasarathy.com