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ShareThe Reserve Bank of India (RBI) is increasingly becoming worried on the impact of higher food prices on inflation. Food prices have been moving up on the back of weak monsoons and they have translated into primary article inflation trending above double-digit levels.
The high levels of primary article inflation will force the RBI to revise upwards its year-end inflation target of 5.4%. The worries of the RBI are seen in its words and actions. Recent speeches by RBI officials stress on maintaining price stability, while the annual report of the central bank released last week dwells on the impact of prolonged accommodative policy on inflation expectations.
The actions of the RBI in giving the market higher cut-offs in yield terms in government bond auctions and rejecting lower bids in yield terms, suggest that RBI does not mind higher bond yields given that inflation expectations are trending higher.
The question the market is asking now is: When will the RBI start ending its accommodative policy? The high levels of liquidity is causing discomfort in both the RBI and government circles, with even the finance minister commenting on the disruptive effects of liquidity on asset prices.
Inflation, even if driven by supply side factors, is politically unacceptable given that it affects the weaker sections of the society the most. The government is doing its best to bring down prices of primary articles through direct intervention.
The RBI now will have to be seen acting in bringing down high system liquidity as part of monetary measures to bring down inflation.
The market worry on expected policy tightening is feeding into higher government bond yields. Ten-year benchmark bond yields are at 7.35% levels and are likely to cross 7.50% levels if bond auctions continue to see a weak response.
The government is scheduled to borrow Rs 50,000 crore in September and banks are increasingly reluctant to bid in auctions on worries of mark-to-market provisioning for the half year ending September 2009.
Inflation as measured by the wholesale price index (WPI) came in at negative 0.95% for the week ended August 14, 2009, against expectations of -1.41%. Inflation is likely to stay negative in the coming weeks on the back of the high base effect, which may wear off sooner than expected, on a sustained rise in primary article inflation.
Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of the RBI remained high, with bids for reverse repo crossing Rs 140,000 crore. Overnight rates were at 3% levels. Liquidity will continue to be high in the system, keeping overnight rates low.
Government bonds
Government bonds saw yields move up week on week, on the back of higher auction cut-offs in terms of yields. The ten-year benchmark bond, the 6.90% 2019, saw yields move up by 2 basis points (bps) to close the week at 7.34% levels. The five-year benchmark bond, the 6.07% 2014, saw yields move up by 6 bps to 7.08% levels, while the 7.94% 2021 bond saw yields move up by 18 bps to 7.98%. The long bond, the 7.40% 2035, saw yields move up by 10 bps to close at 8.20% levels.
The government auctioned Rs 12,000 crore of bonds last week. The papers auctioned were the 7.02% 2016 bond for Rs 6,000 crore, the 7.94% 2021 bond for Rs 4,000 crore and the 8.28% 2032 bond for Rs 2,000 crore. The cut-offs came in at 7.44%, 7.99% and 8.20%, respectively. The government is scheduled to auction Rs 12,000 crore of bonds this week. The bonds to be auctioned are the 6.49% 2015 and the 6.90% 2019 for Rs 5,000 crore each and the 8.24% 2027 bond for Rs 2,000 crore.
The RBI purchased Rs 2,655 crore of bonds in an unscheduled OMO (open market operations) purchase auction last week. The bonds bought were the 7.59% 2016 for Rs 2,460 crore and the 8.20% 2022 bond for Rs 195 crore.
Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bill yields were higher in the 91-day T-bill auction last week, with the cut-off at 3.40%, against a cut-off of 3.36% in the previous auction. The 364-day T-bill auction cut-off came in at 4.34% against a cut-off of 4.10% in the previous auction. The RBI is auctioning Rs 4,500 crore of 91-day T-bills and Rs 1,500 crore of 182-day T-bills this week.
Corporate bond yields were higher week on week following higher government bond yields. Five-year benchmark bonds traded at 8.50% levels while ten-year benchmark bonds traded at 8.85% levels, up 5 bps week on week.
Five-year spreads closed at 130 bps levels while ten-year spreads closed at 140 bps levels. Yields are likely to come under pressure in the coming weeks on the back of rising government bond yields and worries on RBI's liquidity tightening measures.
OIS saw the curve move up week on week. The five-year OIS yield closed higher by 5 bps at 6.43% levels while the 1 year OIS yield closed 2 bps higher at 4.43% levels. The OIS curve will look to follow domestic bond yield movements rather than global bond yields.
Disclaimer : The author is head, fixed income, IDFC Mutual Fund. Views are personal
