Bond yields may surprise on the downside

At different points in time, there is a tendency among those in the market to ignore the negatives and embrace all the positives they can find.

The bond market is in that zone at present with bond and swap yields trending down in the face of rising oil prices, rate hike expectations and worsening government finances.

Players will look for opportunities to buy and take down yields in the remaining part of March.

In April, things will move on supply and geopolitical events. Bond and swap yields are at three-month lows with the benchmark 8.13% 2022 bond yield at levels of 8.04% and the five year overnight index swap yield at 7.85% levels.

Yields have come off from highs of 8.25%, while swap yields have come off from highs of 8.18% over the last one and half months.
Bond yields have declined on the back of buying by banks and a cancellation of an expected Rs10,000 crore auction.

Banks have bought around Rs14,000 crore of bonds in  the last fortnight and this has taken away the floating stock.

Banks bought because they have been aggressively raising deposits in the last two months. They have raised a net Rs110,000 crore in deposits and of this, 24% has to be invested in government bonds.

Banks also try and keep down yields towards fiscal year end to reduce any mark to market losses in their portfolios. Such buying, coupled with lack of fresh supply, means the floating stock is gone.

Traders will be unwilling to go short when there is not enough stock to cover the shorts if required. They would rather go incrementally long in March and take fresh short positions in April as there will be enough supply then to cover the shorts.

This week will be an eventful one. The government releases monthly inflation numbers for February on March 14, and this is expected to come in at around 7.8% from January’s 8.23%.

Lower food prices (food inflation has fallen from highs of over 17% seen in January to below 10% levels) are a positive for inflation, though fuel prices are yet to reflect the sharp rise in oil prices which have gone up by over 30% since January.

Inflation is understated as usual, to the extent of the oil price rise. Inflation expectations, however, are still running high on high oil prices and the hike in coal prices by Coal India by 30% last month. This will be reflected in the March inflation numbers.

The Reserve Bank of India (RBI) will release its mid-quarter monetary policy review on March 17. The central bank is widely expected to raise policy rates by 25 basis points (bps) to bring down inflation expectations. The market will shrug off the rate hikes and continue on its own course.

The release of the borrowing calendar will be of more interest than rate hikes and the inflation data.

The borrowing calendar for the first half of next fiscal will be released in the third week of March and players will closely study the quantum and tenor of securities to be issued. Heavy supply at the mid to longer-end of the curve will lead to a steepening of the curve, if outlook for liquidity is comfortable.

Meantime, yields on money market securities fell on expectations of easing liquidity. One-year certificate of deposit (CD) yields fell by 30bps week on week to close last week at 9.85% levels. CD yields will look to trend down towards the end of the month of expectations of liquidity becoming easy in April.

There were no government bond auctions held last week.

email: arjun@arjunparthasarathy.com