Govt bond yields set to rise sharply

Government bond yields are set to rise sharply as the market sets itself up for the next round of selling. The market received a bit of a relief when the Reserve Bank of India (RBI) hiked policy rates by 25 bps instead of 50 bps as feared. A relief rally took down bond yields by 5 to 7 bps, but the rally will not last long.

There are multiple worries ahead for the market including a central government budget, more policy rate hikes, rising inflation expectations and prolonged liquidity tightness. These worries will filter into bond yields taking them up sharply higher in the coming weeks.

The central government will present the budget for 2011-12 in February-end. The market will start guessing on the size of the borrowing programme based on government’s estimate of a fiscal deficit of 4.8% of GDP.

The subsidy bill of the government has shot up on rise in oil prices (at over $90/bbl oil prices are at two-year highs). The bill is now rising steadily over Rs65,000 crore as the government has indicated that it will not raise diesel prices in the face of rising inflation expectations. Any hopes of the government utilising its excess cash balance of Rs66,000 crore parked with the RBI for reducing its borrowing for the next fiscal has vanished.

The budget promises to be expenditure-driven as seen by initial sound bytes. There is talk of hiking wages under rural employment scheme, hiking minimum support price for crops and spending more on subsidies, given the high inflation prevailing in the economy. The government will be hard pressed to find revenues for its expenditure given that there are no tax reforms on the anvil.

The RBI has signalled further policy rate hikes on the back of rising inflation expectations. Hikes may be gradual but hikes all the same. Inflation expectations are rising despite monetary actions by the RBI. High government spending, supply shortages, rising global commodity prices are all fuelling inflation expectations and there looks to be no respite in sight for inflation. Liquidity is tight in the system despite RBI’s bond purchases of over Rs65,000 crore.

The market is borrowing on an average Rs1,00,000 crore from the RBI on a daily basis. Even if the government draws down on all its cash balances with the RBI, liquidity will still be in deficit. The current state of equity and currency market does not support easing liquidity with foreign institutional investors pulling out money from the country on fears of inflation pulling down economic growth.

Credit markets will be even further pressured on worries of continued liquidity tightness, rising government bond yields and rising cost of borrowing for corporate.

The concern expressed by the RBI on incremental credit deposit ratio which is trending at over 100% will filter down into banks raising loan rates as well as curbing credit to bring down the ratio.
Credit growth at 24% levels will slow down in the coming months while deposit rates will move up as banks shore up on liquidity.

The credit curve is inverted with one year rates at 9.9% and ten year rates at 9.15% levels. The curve will remain inverted but will shift upwards.

Overnight index swaps (OIS) yields came off last week as the market covered paid positions on the back of a lower than expected rate hike.

One-year OIS yields came off by 6 bps while five-year OIS yields came off by 10bps week on week. OIS should see fresh paid positions being put on as worries on government bond yields increase.

The five-year OIS yield should start frontrunning the five-year government bond yield and will start trading at yields higher than the bond yield.

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