Yields may stay firm as bond mart closes 2016

It doesn’t appear to be a fairy-tale ending to bond markets as yields continue to be stickily firm, in low liquidity conditions, as we wind up 2016.

The week started on a quiet note with nothing much to look forward to from data or major events. US yields showed signs of retreating from post Fed-hike high of 2.65%. Crude prices, while firm in recent days, reacted negatively to higher inventory pile up in the US and came off a few dollars. Meanwhile, the US dollar index also retreated from its 13-year high as real money managers looked to square up ahead of Christmas holidays.  Stock markets saw a bumpy ride with sharp swings, as both Dow Jones and S&P500 consolidates near historic highs. Sentiment is extremely positive as investors expect continuation of bull run in equities due to lower taxes and lesser regulation under the new administration. It also appears to herald a grand rotation with money moving into equities from bonds.

Indian fixed income markets appears to be witnessing change of policy dynamics as the Reserve Bank of India (RBI)’s recent stance of keeping liquidity neutral and expressing caution on upside risks to inflation discourages traders and investors in buying duration. The yield curve has steepened with the 10-year over overnight at 29 basis points (bps), close to the pre demonetization times. Part of this shift in perception is due to the policy stance of RBI, which was further reinforced by the minutes of the Monetary Policy Commitee (MPC) released last week, and partly due to perception of a steeper upward slope for the Fed action next year.

Markets tend to run ahead of events and the recent repricing of risk in Indian markets could well be one. The sell off in bonds should therefore be seen as an opportunity for the reasons that follow. Both the downward revision to growth and worries of spurt in core inflation numbers could surprise positively and may warrant an early rate cut domestically. The net deposit accretion to the banking system, as a result of demonetization should also result in mandatory buying of bonds, in an environment where demand for credit is likely to be weak for a few quarters

On the auction front, Friday’s auction of dated securities and FRBs of 14,000 crore went off well with a bid to cover ratio of 3.12. There was no devolvement and the long tenor bond was absorbed by one bidder. The newly auctioned 13-year bond saw a cut off of 6.79%, in line with expectations. Money market rates are largely unchanged and at a system level, banks have placed Rs 6.3 lakh crore of funds with the RBI. Sentiment continues to be weak with barely five trading days left in the year. Foreign institutional investors have been noted to be net sellers in government securities while sporadically buying corporate bonds, from November. The benchmark 10-year bond is expected to trade 6.55-6.45 range. Data on demonetization collection, GST rollout date and expectations from the Federal 2017 budget will be near-term interests for participants

The writer is executive director, Lakshmi Vilas Bank