Market levels yet to factor in ground reality

The bond market is staring at policy rate hikes, tight liquidity, rising inflation expectations and higher than budgeted government bond supply, yet yields are down by 15 basis points (bps) from pre-budget levels.

Yields on the well-traded 8.13% 2022 gilt closed last week at 8.10% levels, down from highs of 8.25% seen last month.

Five- and ten-year corporate bond yields are trading at 9.15% and 9.20% levels, respectively, down 5bps from highs, while five-year interest rate swap yields are trading at 7.97% levels, down 15bps from highs.

The market levels seem benign in relation to the negatives ahead and levels will have to realign to factor in the negatives. This would mean yields moving up to levels from which it came down and then trending even higher as bond supply in April gives traders positions to sell.

The Reserve Bank of India (RBI) raised repo and reverse repo rates in the policy review last week and has signalled that the policy stance will be anti-inflationary.

The central bank sees threats to inflation
in the form of rising oil prices due to political unrest in the Middle East and in the form
of Japan shifting from nuclear to thermal
power.

Manufacturing inflation is trending higher at 6.1% in February from 4.8% in January and that has raised further concerns on the inflation front as it is now seen as more demand driven rather than supply led.

March inflation forecast has been upped to 8% from 7% and this revision coming on the back of many previous upward revisions indicates that the RBI has been more sanguine on inflation than warranted.

It wants to set their record straight on inflation and hence has signalled reigning in inflation expectations as the primary objective in the coming months. This would mean further policy rate hikes coupled with liquidity conditions being maintained in deficit mode. The RBI would also like to see credit growth come down from 23% levels to 20% levels in line with their tightening policy stance.

Oil prices ruling consistently at over $110 a barrel is a clear danger to both inflation as well as government finances. High oil prices raise inflation expectations, while government finances take a hit on higher subsidy payouts.

The market has to an extent factored in rising inflation expectations but it has yet to start factoring in higher than budgeted government bond supply. Higher bond supply is negative for the market if there is no corresponding increase in demand.

The hike in interest rates by the Employees Provident Fund Organisation (EPFO) from 8.5% to 9.5% is another negative for the market.

The fund invests all its corpus in fixed income securities and for it to generate a return of 9.5%, the fund has to invest in securities that yield around 9.5%.

The fund will have to start demanding higher yield on its investments, pushing up yields in the economy.

On the global front, China, last week, raised its bank reserve requirements for the third time this year.

China is seeing inflation trending at close to 5% levels and views inflation as a threat to the economy. The country has stated that its primary objective for this year will be to bring down inflation expectations.

Liquidity tightened last week on the back of advance tax outflows. Liquidity as measured by bids for repo in the liquidity adjustment facility (LAF) auction of the RBI saw bids average

Rs126,000 crore last week from levels of Rs57,000 crore seen in the week previous to last.

Liquidity is expected to ease out first week of April on the back of government spending. Demand for funds by the banking system will be high till end March as banks balance their books for the fiscal year end.

Money market security yields moved higher with one-year bank certificates of deposit (CDs) yields rising by 15bps week on week to close at 10% levels. CD rates will trend higher this week on demand for funds by banks.
Overnight rates moved higher on the back of hike in policy rates with call money rates trading at 7.45% levels post policy from pre policy levels of 6.90%. Call rates will trade at levels of 7.45% this week on the back of tight liquidity conditions.

Government bond auction
There were no government bond auctions held last week.
    email: arjun@arjunparthasarathy.com