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The yield difference between the Indian and the US 10-year benchmark bonds is, at the current levels of 530 basis points, close to 10-year highs.

The spread has widened by almost 110 basis points (bps) over the last three months, with the 10-year US treasury yield falling 60bps and the Indian 10-year benchmark gilt yield moving up 50bps. The lowest the spread has gone to is 32bps, seen in calendar 2004.

The average spread over the last 10 years is around 320bps, and the current spread is 210bps off the 10-year average. There is a case for the spreads to narrow, not due to its historical nature, but more due to the future outlook of the two benchmarks.

The US 10-year yield has fallen from highs of 4% seen this year to current levels of 2.7% on the back of increased demand for risk-free assets in the face of weakening economic growth. The market has all but forgotten the size of the US fiscal deficit — 10.6% of GDP as — well as the inflationary impact of the expansion of the US Federal Reserve’s balance sheet and the waning demand for US debt by foreigners in the wake of a weakening dollar.

In taking down US 10-year yields, the market has chosen to focus on weak employment numbers at 9.5% and soft economic data and the fact that the Fed is expected to maintain rates at zero percent levels in the face of falling inflation expectations.

In India, inflation has been the key driver of bond yields. Inflation as measured by the wholesale price inflation has been in double digits for the past few months and the markets have been nervous on the inability of policy makers to judge inflation.

On the other hand, fiscal deficit numbers have been better at 5.5% of GDP as against 6.8% of GDP seen last year. Demand for bonds has been resilient despite slow deposit growth (at below 15% against the previous year’s levels of 18%) as seen from the success of each government bond auction.

Government finances are looking healthier than last year with the success of the 3G spectrum auction and improved tax collections (up 20% over year). The last couple of readings of the industrial production data came in below expectations, leading to slower growth expectations. Outlook for inflation is better with monsoons being close to normal as well as global commodity prices stabilising.

Going by future outlook, a soft but positively growing US economy will keep bond yields steady at lower levels while stabilising inflation outlook coupled with improved government finances will bring down Indian bond yields. This should bring down the yield differential.

Liquidity
Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility auction of the Reserve Bank of India was easy last week, with bids for reverse repo at 4.50% averaging Rs 10,000 crore for the week.

Liquidity is expected to stay easy on account of fall in demand for funds in the reporting week.

Overnight rates will hover around reverse repo rates of 4.50% this week.

Government bonds
Government bonds saw 10-year yields close almost flat week-on-week, with the 7.80% 2020 yield closing at 7.97% levels.

The 8.13% 2022 yield moved up 7bps to 8.05% levels on the back of the issuance of the 8.08% 2022. The 7.17% 2015 saw yields close almost flat at 7.71% levels, while yields on the long bond — the 8.30% 2040 — closed unchanged at 8.39% levels.

Government bonds will remain choppy as the market juggles between three securities — the 7.80% 2020, the 8.13% 2022 and the 8.08% 2022.

The government auctioned Rs 12,000 crore of bonds last week — the 7.46% 2017 for Rs 4,000 crore, the 8.08% 2022 for Rs 5,000 crore and the 8.30% 2040 for Rs 3,000 crore. Cut-offs came in at 8.01%, 8.03% and 8.40%, respectively.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were lower in the 91-day note auction on September 1, with the cut-off coming in at 6.07% against 6.19% in the previous auction. The 182-day paper saw cut-off of 6.37% against 6.46% in the previous auction. This week, the RBI is auctioning Rs 2,000 crore of 91-day T-bills and Rs 1,000 crore of 182 day T-bills.

Corporate bonds yields closed lower week-on-week with five-year bond yields trading lower by 3bps and 10-year bond yields trading lower by 2bps week-on-week. Five-year AAA bond yields closed last week at 8.52% levels while 10-year AAA bond yields closed at 8.74% levels.Five- and 10-year spreads closed down 2bps each at 68bps and 61bps respectively. Corporate bond yields are likely to stay steady at current levels on the back of improved liquidity sentiments.

Overnight index swaps (OIS) saw the curve flatten week-on-week. The five-year OIS yield closed down 7bps at 6.98% levels, while the one year OIS yield closed flat at 6.13% levels. The one-over-five spread closed down 7bps at 85bps levels. The curve is likely to stay ranged on lack of clear directional factors.

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