Policy actions to have little impact on markets

The market has positioned itself for a more fundamental shift in interest rates and Reserve Bank of India’s expected policy actions will have little impact on yield levels.

The 10-year benchmark bond yield is at 8.17% levels while five-year interest rate swap yields are at 8.04%. The one-year cost of borrowing for banks is 9.85%, while five- and ten-year corporate bonds are trading at 9.18% and 9.10%, respectively.

The RBI policy rates of repo and reverse repo are at 6.5% and 5.5%, respectively way below the market yields of bonds, swaps and money market securities.

Any increase in the overnight rates, which is widely expected by the market, will have little or no impact on government bonds, corporate bonds, money market and swap yields.

The market is factoring in continued tight liquidity conditions, rising inflation expectations and heavy bond supply from the government in fiscal 2011-12.

The RBI cannot really do much on any of these factors and if they do try to address one factor it will be at the cost of the other factors. If RBI cuts cash reserve ratio (CRR) or buys government bonds in the secondary market through open market operations (OMO) in order to ease liquidity, government borrowing and inflation expectations will rise.

If RBI raises policy rates in bigger steps, liquidity will tighten and government borrowing costs will go up.

If RBI tries to cushion government bond supply by buying government bonds, then inflation expectations will rise. The market will wait for further opportunities to go short in this environment and any respite given by RBI in the form of liquidity easing measures will prompt the market to increase their shorts.

The government is always there for the market to cover their shorts. Liquidity tightened and bond and swap yields rose last week. Liquidity as measured by bids for reverse repo/repo in the Liquidity Adjustment Facility (LAF) of the RBI saw bids for repo average Rs111,000 crore on a daily basis. The bids for repo averaged Rs80,000 crore in the week before last.

Liquidity tightened on account of fresh product covering by banks ahead of the credit policy. Government bond yields rose week on week with the actively traded 8.08% 2022 bond yield rising by 6 basis points week on week. The bond saw muted response in the auction leading to demand worries in the market. Overnight Index Swaps (OIS) yields rose week on week with the one-year OIS yield rising by 12 bps week on week and the five year OIS yield rising by 11 bps week on week. The curve is factoring in pressure on interest rates on account of inflation and liquidity.

Money market yields rose with one year bank CD (Certificate of Deposit) rates moving up 7 bps week on week. Five- and ten-year corporate bond yields moved higher by 5 bps and 7bps, respectively. Corporate bond yields are rising on account of continued tight liquidity conditions and lack of demand.
Inflation as measured by the Wholesale Price Index (WPI) for December 2010 came in at 8.43% against November 2010 number of 7.48%. The RBI is hard-pressed to act on inflation which is rising continuously above estimates.

Primary article inflation at 17% and an understated fuel price inflation at 11.53% are not helping matters. RBI is expected to signal a higher inflation forecast for March-end.   

Government bond auction
The government auctioned Rs11,000 crore of bonds last week. The bonds auctioned were the 7.99% 2017 bond for Rs4,000 crore, the 8.08% 2022 bond for Rs4,000 crore and the 8.26% 2027 bond for Rs3,000 crore. The cut-offs came in at 8.19%, 8.25% and 8.53%, respectively. The auction was fully subscribed.

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