Govt borrowings to set tone, yields seen mid 6.70s

It was a risk aversion theme for most markets last week as the crucial passage of American Health Care Act bill was keenly looked forward to in developed markets. The Indian markets continued to be hostage to knee-jerk reactions to news-headlines, with the last week of the FY to dawn.

There was setback to the Trump agenda as his government failed to gain sufficient majority to pass the AHCA bill (which would repeal the Affordable Care Act, more popularly known as ObamaCare) and the famed Trump trade gave way to risk-aversion trades. Arising out of this, US Treasuries moved higher and curve-flattening was the favored trading theme. The setback in gaining majority for the passage of the bill would mean the prospect for significant fiscal stimulus would be dim. US 10-year note ended at 2.41% and US Dollar weakened against most majors. Yen was the biggest beneficiary, while crude prices slumped and CBOE's Volatility Index (VIX) rose to 12.4.

In other key development British Prime Minister announced that UK will notify European Union on 29th March of its intent to leave the EU, that should begin the two-year period set out in Article 50 of the Lisbon Treaty. The terms of reference for exit will be discussed during this two-year period. Negotiations and counter-negotiations should follow and may be thorny as EU could be loath to give the UK a "good" deal for fear of prompting more similar exits.

Indian markets played proxy to the global short-term pause in the reflation trade. Bond yields have been drifting lower in choppy two-way moves amid thin and volatile liquidity. Major buying has been coming from FIIs/FPIs and for the first time, the bond traders appear to be veering towards the view that yield curve steepening may take a breather. Likely reasons being RBI's February policy stance virtually seals prospects of further rate hikes and the resultant pricing-in of curve-steepening has run its course. And falling global crude prices coupled with recent rupee strength should lower the Indian basket of crude price. Above all, the large supply of State loans and Uday Bonds that have been characteristic of last few months should pause in the first half.

There was also talk of introduction of Standing Deposit Facility, a thought process that gained currency in 2014. The first round of meeting between government and Bank officials took place and in a few more rounds, the modalities should be out. The moot point would be if the interest rate that is agreed upon is lower than the current repo rate, will it influence other money market rates and be a trigger for another round of lower lending rates. Or will it cause further steepening of short term rates in an environment where credit demand is terribly poor?

While bonds sold off on the news of introduction of SDF, the selling was also on account of weekend and lighter positioning on global worries. Finally, announcement of another round of State loans next week alongside buy-back from a leading state may be seen as liquidity neutral developments.

Participants await the borrowing calendar for H1 FY 2018 which will be a key driver for investment and duration strategies in a changed monetary environment.

A wider than expected current account deficit, due to drop in receipts of net invisibles, did not deter rupee bulls as strong flows kept the local currency strong. Bond yields may dabble the mid 6.70s if the auction calendar is favourable or the much expected special dispensation from the regulator comes forth.

The writer is executive director, Lakshmi Vilas Bank