Market will go positive into the Union Budget

There are many factors that are actually positive for bond yields in the short term.
These are:

• a) the government has completed its borrowing programme for the current financial year and there are no scheduled auctions in the near term;
• b) Budget expectations are not negative;
• c) the broad market is sitting short on bonds; and,
• d) there is good cushion in the yield curve for further expected rate hikes by the Reserve Bank of India. If the Budget meets the market’s expectations there is likely to be a rally of 15-20 basis points.

The well-traded benchmark bond yields are at 8.15% and a good Budget can bring down the yields to below 8%.

The government has borrowed Rs439,000 crore through issue of dated bonds this year. This is lower by Rs18,000 crore from the budgeted Rs457,000 crore as excess revenues from 3G auctions bolstered government’s finances.

The government may issue Rs8,000 crore of bonds to make up for some reduced auction sizes earlier, but that is unlikely to worry the markets.

The main worry is the absorption of fresh supply in April, which will keep a potential rally capped. Players are expecting a gross borrowing of Rs430,000 crore to be announced in the Budget, and the borrowing process is expected to be frontloaded but the amount itself is not seen as a big threat to yields as of now.
The market is short government bonds as seen from the movement in yields over the last one year.

Yields have moved steadily upwards with lacklustre volumes. The ten-year benchmark yields are up by 30 bps over the year.
The RBI has taken away excess floating stock through bond purchases of over Rs65,000 crore. Traders are sitting light-to-short, while investors have stayed on the sidelines.

The whiff of a potential rally will bring this segment back into the market leading to a further fall in yields.

The repo rate at 6.5% is still 160 bps off the ten-year benchmark yield of 8.1%. The market is expecting the RBI to raise repo rates and the spread is large enough to provide a decent cushion.
The negatives are still very much out there in the form of tight liquidity, rising inflation expectations and worries on government finances given the rising subsidy bill.

However, these negatives are known and the market will factor them in when they look at the yields post the Budget.

Liquidity tightened last week with the market borrowing over Rs100,000 crore on a daily basis from the RBI. It is expected to get tighter in March given traditional fiscal year-end demand for funds and advance tax outflows.

Government spending may negate part of the tightness but liquidity will still remain in deep negative territory in March.
Inflation expectations are high with oil prices ruling at over $100 per barrel.

This is affecting subsidies as well as inflation as the subsidy bill is rising steadily to over Rs100,000 crore, while inflation is understated to the extent of non-passthrough of fuel price hikes. Inflation for January came in at 8.23% and its stickiness is worrying policy makers. The Budget itself is expected to be anti-inflationary.

A populist Budget will make the market sell-off any positions held in expectations of a rally and this will lead to a sharp rise in yields.

The market is expected to go long rather than short into the Budget and yields will see positive movements this week, while swap (OIS or overnight index swaps) yields will also follow suit.

Five year swaps at 8.03% will see receiving interest leading to a flattening of the curve as one year swap yields at 7.47% will remain sticky on account of liquidity and rate hike worries.

Corporate bond yields will not see any rally given liquidity tightness while money market yields will remain pressured at higher levels on demand for funds by the banking system.

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