Bond St to start worrying about rate rise, supply

The budget provided the bond market the rally it wanted. The lower-than-expected net borrowing of Rs343,000 crore - the consensus call was around Rs380,000 crore — gave players a reason to cheer, and yields came off by 8 basis points (bps) to 14 bps across the curve.

The rally looks to be over given three major negative factors looming on the horizon.

The first is oil prices, which have crossed $115 per barrel (Brent crude) on the back of unrest in the Middle East. The uprising does not to look like dying down soon and if oil remains at higher levels, the government will be forced to raise oil prices to temper the losses incurred by oil marketing companies and this will lead to higher inflation expectations.

High oil prices also lead to budget calculations on subsidies going awry, and the government will end up paying more on subsidies than it budgeted for, leading to higher fiscal deficit and higher-than-budgeted government borrowing.

The second negative is the expectations of policy rate hikes in the mid-term policy review of the Reserve Bank of India (RBI) in mid-March.

The finance minister said in his budget announcement that the RBI will take more monetary steps to bring down inflation expectations and that the central bank will raise rates in its policy review.

The third negative will be the front-loading of the government borrowing program. The Centre usually completes around 65% of its borrowings in the first half of the fiscal year and given a gross borrowing of around Rs415,000 crore, the government will be borrowing around Rs270,000 crore in the first six months of fiscal 2011-12.

Initially, weekly borrowing sizes will be in the range of Rs12,000 crore to Rs15,000 crore. The market will be faced with this fresh supply starting April and given bond redemptions for April-June at Rs13,500 crore, the supply has to be met in full.

Yields will start reflecting a pessimistic outlook on rates in the expected Rs10,000 crore auction this week.

Liquidity looks to be the only positive factor on the horizon - it should enter positive territory starting April, after being in negative territory for the last eight months.

Liquidity as measured by bids for repo/reverse repo in the liquidity adjustment facility (LAF) auctions of the RBI, seeing bids for repo on a daily basis.

Banks were borrowing from the RBI at the repo rate on a daily basis. Liquidity has eased considerably over the last few months on the back of government spending, buying of Rs65,000 crore of bonds by the RBI and higher deposit growth.

The systemic liquidity at present is around a negative Rs50,000 crore. Against this, the government has Rs28,000 crore parked with the RBI, while banks have Rs95,000 crore parked with mutual funds.

The government will spend over Rs65,000 crore this month of which Rs29,000 crore will be on subsidies.

Banks have been raising their deposit growth rates to bring down the incremental credit deposit ratio to below 100% levels. Deposit rates have been raised to garner more deposits and this is reflected in the 16.9% growth in deposits as of February, against a growth rate of below 15% seen in the second half of calendar year 2010.

Higher deposit growth will add to the liquidity in the system.

Government bond auction
There were no government bond auctions last week.