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The bond market is keenly awaiting the government borrowing numbers for fiscal 2010-11. The amount will be given in the Union Budget to be presented to the Parliament on February 26.

The direction of interest rates for the near term will be determined by the borrowing numbers falling short/ meeting or exceeding market expectations.

In the longer term, the fundamentals of demand supply and other interest rate-moving factors such as inflation (it was a moving factor some time ago but it does look like it may have been thrown out of the door by policy makers though markets may have a different view), government finances etc will set the trend.

Ten-year bond yields traded in a 7.85% to 7.95% through last week and the Budget will drive the yields up or down. The market’s expectation of the borrowing numbers in the Budget is around Rs 450,000-475,000 crore gross, which would translate to a net number of Rs 345,000-365,000 crore.

Borrowing numbers below Rs 450,000 crore or above Rs 475,000 crore will take bond yields down/up while numbers at market expectations may see a short rally given that the market is sitting light and there is no imminent supply for the next one month if government sources are to be believed.

The real test for yields will come when the first supply of bonds hits the market in April 2010. The fact that the banking system is heavy on government bonds, with most nationalised banks sitting on 28% to 30% SLR (statutory liquidity ratio) levels, will mean that demand for bonds may not be high, leading to higher yield cut-offs at the auctions.

April is also the month of an annual policy setting by the Reserve Bank of India (RBI) and there are wide expectations of rate hikes on the back of indications given by the central bank after its last review in January. The market will be wary of absorbing April auctions at lower levels of yields.

Inflation as measured by the WPI (wholesale price index) came in at 8.56% for December 2010 against market expectations of 8.21%.

The RBI’s WPI forecast for March 2010 has already been breached in December 2009 and given the trend in fuel and primary article inflation (running at 9.9% and 16% respectively), WPI for January is likely to be surprise on the upside.

On the global front, the hike in discount rate (where banks can access Fed window for funds directly) by 25 basis points (bps) created a lot of noise. On the ground, the hike is immaterial as the Fed is under pressure from the market and the US government to keep policy rates low to support growth and loose fiscal policy.

The focus is turning from Greece to the UK, whose deficit is looking to go out of hand. The UK showed a deficit in January 2010 from expectations of a surplus due to fall in tax collections.

Ten-year gilt yields went up to one-and-a-half-year high of 4.17%.
Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of the RBI, held at week before last’s levels, with bids for reverse repo at 3.25% at around Rs 65,000 crore.

Liquidity was comfortable despite the 50 bps hike in CRR (cash reserve ratio) sucking out Rs 24,000 crore from the system. Overnight rates were at reverse repo levels of 3.25% and may see some pressure as liquidity is expected to tighten in March 2010.

Government bonds
Government bonds saw yields move marginally higher across the curve on worries about inflation, rate hikes and government borrowing. The ten-year bond, the 6.35% 2020, saw yields close the week at 7.88% levels, down 2 bps week on week.

The five-year bond, the 7.32% 2014, saw yields close up 6 bps at 7.34% levels. The 7.02% 2016 bond saw yields close flat at 7.66% levels and the 8.24% 2027 bond yield closed higher by 1 bps at 8.38% levels.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher in the 91-day paper auction on February 17, with the cut off coming in at 4.13% against a cut off of 4.09% in the previous auction.

The 182-day T-bill auction saw the cut off at 4.55% against a cut-off of 4.49% in the previous auction. The RBI is auctioning Rs 5,000 crore of 91-day T-bills and Rs 3,000 crore of 364-day T-bills this week.

Corporate bonds saw yields move up sharply across the curve. One year certificate of deposits (CD) rates moved higher by 50 bps to close at 7% levels while three-year corporate bond yields moved up by 25 bps to close at 8% levels. Five- and ten-year corporate bond yields moved up by 15 bps to close at 8.65% and 8.95% respectively.

Five and ten year credit spreads closed up by 10 bps at 91 bps and 115 bps, respectively. Credit spreads are likely to move up on the back of liquidity worries.

Overnight index swaps (OIS) saw the curve move down week-on-week as the cost of running paid positions took its toll.

The five-year OIS yield closed 5 bps lower at 7.07% levels while the one-year OIS yield closed down 1 bps at 4.97% levels. The one-over-five spread closed down 4 bps at 210 bps levels.

The OIS curve is likely to trade in a tight range as high spreads keep paying interest low at higher levels while interest rate worries keep receiving interest low.

Disclaimer: The writer is head - fixed income,IDFC Mutual Fund. Views are personal.