Swap yields are front-running a bond rally

The interest rate swap (IRS) market is usually a front runner for bond yields. The sharp fall in five year OIS (overnight index swaps) yields indicates that bonds yields are in for a sharp rally too. Five year OIS yields closed last week at 7.70% levels, down 20 basis points (bps) week-on-week and 60 bps month-on-month.

The benchmark 10-year bond, the 7.80% 2021 bond, closed last week at 8.23% levels, down 3 bps week-on-week and almost flat month-on-month. The chart gives the movement of 10-year bond yield and five year OIS yield over the last two months.

The 10-year bond and the 5-year OIS yield movements suggest that the former follows the direction of the latter, with a lag. Hence, the sharp fall in 5-year OIS yields does suggest an impending rally in the 10-year bond yield.

The swap market, being a leveraged market, reacts quickly to expected events. Swap yields moved up sharply when the RBI hiked the repo rate by 50 bps in May. This was due to the fact that the market was expecting more rates hikes by the RBI on the back of rising inflation expectations.

The reversal in yields with the 5-year OIS yield falling by 60 bps month-on-month is a sign that the market is now betting on the RBI maintaining status quo on rates in the mid quarter policy review on June 16. Swap yields are unlikely to react negatively even if the RBI raises rates by 25 bps as the market will take it as the last of the rate hikes. Swap yields will react negatively if RBI raises rates and signals further rate hikes ahead.
I have been saying in my columns that rates hikes are over and done with. The 50 bps hike in May has given the RBI room to study factors that affect inflation and inflation expectations. The RBI hedged its bets on inflation by forecasting that inflation, as measured by the wholesale price index, or WPI, will print at higher levels (close to 9% levels) in the first six months of the 2011-12 fiscal. Fuel price hikes and high oil prices are unlikely to alter RBI’s judgment on inflation.

The factors driving inflation are not apparent at present. The global economy is showing signs of slowdown with unemployment in the US continuing to stay at 9% levels, China tightening rates in the face of inflation taking its effect on growth expectations and eurozone sovereign debt issues gaining ground to affect region’s growth. India’s IIP (index of industrial production) growth for April 2011 came in at 6.3% (4.4% old series).

The index contracted by 1% month-on-month. Vehicle sales growth at a 20-month low in May 2011 is indicating that rate hikes and inflation are taking their toll on consumer demand. Central banks of the eurozone, Australia and Korea have all put rate hikes on hold on slowing growth signs. The RBI will follow suit and maintain rates status quo while stating that containing inflation expectations will still be its primary objective.

Liquidity and inverted yields curves are also helping the RBI in monetary transmission. Liquidity continues to stay in a deficit mode with the system borrowing from the RBI on a daily basis. Tight liquidity conditions is keeping short end rates high with one year borrowing costs for banks at close to 10% levels. Banks have hiked lending rates in the face of high borrowing costs leading to consumer demand cooling off.

Global economy, domestic liquidity and interest rates are all in favour of inflation coming off. The RBI has enough reasons to stay with current policy rates.

Government bond auction
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs3000 crore, the 7.80% 2021 bond for Rs6000 crore and the 8.26% 2027 bond for Rs3000 crore. The cut offs came in at 8.30%, 8.25% and 8.59%, respectively. There are no government bond auctions scheduled for this week.