Column

Inflation as measured by the wholesale price index (WPI) is expected to come in below 7% for January 2012. The market expectation for inflation is around 6.7% and if it comes at or even below it, rate-cut expectations will start building into bond prices.

The Reserve Bank of India (RBI) target for March inflation is around 7% and with the base effect helping inflation and food prices showing a downward trend, March inflation could surprise on the downside.

The government stopped releasing weekly inflation numbers, citing volatile data. The last reading of primary article inflation as of January 14, 2012, was 1.89% and food inflation was negative 1.03%.

RBI has indicated that falling inflation trends will enable it to cut the benchmark repo rate. RBI cut the cash reserve ratio (CRR) by 50 bps in its January 2012 policy review, but refrained from cutting the repo rate as inflation for December 2011 at 7.5% was still above RBI’s comfort levels. Inflation at below 7% levels can allow the central bank to cut the repo by 50 bps in its March review.

Liquidity conditions will also be tight in March due to advance-tax payments and traditional year-end demand for funds. RBI is likely to cut CRR by 50 bps in March to ease liquidity pressures.

The government bond auctions are at its last stages. There are only three more bond auctions of Rs12,000 crore each for this fiscal and the markets will not really worry about open market operations (OMOs) to absorb the supply.

The market will start positioning for rate cuts in March. The ten-year benchmark bond, the 8.79% 2021 bond, closed the last week at yields of 8.19%, up 4 bps week on week but down from intra-week highs of 8.27%.

The yield rose because RBI did not carry out a bond purchase auction as part of its OMO to infuse liquidity into the system. RBI is maintaining that it will use OMO as and when necessary. The yield on the ten-year bond could trend towards 8% levels as markets start factoring in rate cuts on the back of lower inflation numbers.

Inflation disappointing the market and coming in above 7% levels could spoil sentiments and yields will then trend up from lows as markets sell long positions built on rate-cut expectations.

Corporate bond markets saw five- and ten-year benchmark AAA credit spreads close down by 7 bps and 1 bps week on week, respectively, largely on the back of rising government bond yields.

Credit spreads will move up from levels of 88 bps for five-year and 85 bps for ten-year corporate bonds as government bonds rally on rate-cut expectations. Tight liquidity conditions will keep corporate bonds from rallying sharply.

The interest-rate swap curve rose on the back of rising prices of equities.

Risk aversion built into five-year overnight index swap (OIS) yields was taken off by market players leading to a 14 bps rise in yields week on week.

The swap curve will stabilise at current levels and will trend down on the back of rate-cut expectations.

Liquidity as measured by bids for repo in the LAF (liquidity adjustment facility) auction of RBI eased by around Rs14,000 crore last week.

The government running up an overdraft of around Rs17,000 crore with RBI helped ease liquidity. Liquidity conditions are expected to remain in and around `100,000 crore negative, given the fiscal year-end pressures.

Government bond auctions
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 8.19% 2020 for Rs3,000 crore, the 9.15% 2024 bond for Rs6,000 crore, and the 8.97% 2030 bond for Rs3,000 crore.

The cut-offs came in at 8.28%, 8.32% and 8.62%, respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.

The writer is editor of www.investorsareidiots.com, a website for investors