Positive cues for interest rates

Interest rate sentiments are set to turn positive on the back of global and domestic factors. Yields on the domestic 10-year benchmark bond had touched peaks of 7.92% on worries of inflation, rate hikes and liquidity.

Yields had risen despite positive global cues, but this trend is likely to change in the coming weeks, the primary reason being worries to global economic growth filtering into domestic growth and inflation trends.

Domestic interest-rate markets will have to start factoring in growth coming off on weak global growth prospects and inflation outlook improving on falling commodity prices. The worry for markets is domestic liquidity, which is expected to be tight on the back of slowing money supply growth, large trade balances and slowing capital flows. Tight liquidity, however, is an inflation damper which is positive for interest rates.

Bond yields across the globe collapsed last week as incremental data in the US, China and the Eurozone showed weak economic growth prospects.

The US unemployment rate is holding steady at 9.5%, prompting the US Federal Reserve (Fed) to maintain its balance sheet size rather than shrinking it.

The Fed has stated that it will purchase long US treasuries from the proceeds that come as the securities on its books mature.

China’s import growth numbers for July came in weaker than expected, leading to questions of domestic demand growth in the country. The Eurozone is facing a debt crisis, leading to negative growth prospects for some of its economies. US treasuries, German bunds, UK gilts and Japanese government bond yields have fallen to multi-year lows on the back of weak economic growth prospects.

Oil prices fell sharply from $81 a barrel to $75/bbl on the back of weak growth data.

Industrial production growth for India showed a weaker- than-expected trend with growth coming in at 7.1% for June against expectations of 8.1%. Inflation, as measured by the wholesale price index (WPI) for July is expected to come in at 10.10% if government sources are to be believed. The market is expecting inflation to come in at 10.50%.

The weaker-than-expected industrial numbers, coupled with lower-than-expected inflation numbers, is accompanied by weak global growth prospects. The RBI will maintain its pace of policy rate hikes given its move to normalisation, but the market will start factoring in falling growth and inflation expectations in bond yields.
Liquidity

The outlook for liquidity is bleak. Money supply growth — as measured by M3 or broad money supply — is trending at below 15% levels, and the market is borrowing from the RBI to fund its daily mismatches. September will see advance tax outflows of around Rs50,000 crore while demand for funds will increase on half-yearly balancing of books by the banking system.

The festive season will cause increase in currency in circulation. In all this, if capital flows decrease due to risk aversion and the rupee depreciates against the dollar, the sentiment for liquidity will turn extremely negative.

Tight liquidity is positive for interest rates at the long end of the risk-free curve as inflation expectations come off, but the short end of the curve will face the brunt of liquidity tightness. Money market instruments and corporate bonds at the short end of the curve will see yields move up sharply as demand vanishes due to liquidity tightness.

Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility) auction of the RBI tightened on fresh demand for funds from the banking system. Bids for repo at 5.75% averaged Rs9,600 crore last week. Liquidity is expected to stay tight on fresh product covering by banks and overnight rates will hover around repo rates of 5.75%

Government bonds
Government bonds saw a rally in the newly issued 8.13% 2022 with the yield rallying 13bps week-on-week to close at 7.96% levels. The market perceives the bond to be an on-the-run security as the outstanding stock is low and the bond is likely to see further issuances in the next few months.

The benchmark 10-year bond yield closed flat at 7.82% levels, while the 7.17% 2015 saw yields close down 5 bps at 7.62% levels. The long bond — the 8.30% 2040 — yield closed higher by 4 bps at 8.38% levels. Gilt yields are likely move down on the back of positive interest rate sentiments.

The government auctioned Rs12,000 crore of bonds last week — the 7.46% 2017 and the 8.13% 2022 for Rs5,000 crore each, and the 8.32% 2032 for Rs3,000 crore. The cut-offs came in at 7.93%, 8.13% and 8.41%, respectively.

Treasury bills, corporate bonds and overnight index swaps

Treasury bill (T-bill) yields were higher in the 91-day paper auction held on August 11, with the cut-off coming in at 6.15% against 5.98% in the previous auction. The 364-day T-bill auction saw the cut-off coming in at 6.42% against 6.30% in the previous auction. The RBI is auctioning Rs7,000 crore of 91-day and Rs1,500 crore of 182-day paper this week.

Corporate bond yields moved down week on week on buying at higher levels. Five-year AAA bonds traded lower by 5 bps at 8.50% levels while 10-year AAAs traded lower by 3bps at 8.80% levels. Credit spreads moved down with five-year and 10-year spreads closing lower by 4 bps each at 73 bps and 84 bps respectively. Corporate bond spreads will move up on liquidity worries.

Overnight index swaps (OIS) saw the curve steepen week on week as the market received five-year swaps on the back of a rally in US swap yields. The five-year OIS yield closed down 26 bps at 7.04% levels while the one year OIS yield closed down 6 bps at 6.21% levels. The one-over-five spread closed down by 20 bps at 83 bps levels. The swap curve will flatten further on the back of better interest rate sentiments and tight liquidity conditions.
 

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