Comment

Higher inflation and MSS ceiling negatives for interest rates

The bond market will go into the new week with some negative news on interest rates. The Reserve Bank of India (RBI) on Thursday increased the ceiling on MSS (market stabilisation scheme) bonds by Rs 50,000 crore to Rs 2,00,000 crore.

The MSS outstanding as of October 5, 2007, was Rs 1,44,940 crore.

The higher MSS limit stems from the surge in currency flows into the country. The RBI has been actively buying US dollars to prevent any sharp fall in the domestic currency.

The buying has taken the liquidity in the system to over Rs 50,000 crore. Further currency flows may require measures such as a hike in the cash reserve ratio (CRR) of banks.

The higher-than-expected rise in inflation is also a dampener for interest rates. The WPI (wholesale price index) growth came in at 3.42% for the week ended September 22, 2007, against expectations of 3.20%.

The higher prices of primary articles and manufactured products contributed to the rise in the index. The rising trend in WPI, with the base effect waning, may take inflation higher than expected.

The September 2007 US non farm payroll numbers released on Friday came in above expectations at 110,000 jobs were added against market expectations of 100,000 job additions.

The previous month number was revised from negative 4000 to 89,000 additions. The positive non farm payroll numbers indicate that the US Fed may not cut interest rates further.

This week will see the RBI auctioning Rs 10,000 crore of dated bonds under the government borrowing program and Rs 4,900 crore of state government bonds under the state development loans.

It will also auction Rs 8,000 crore of dated bonds under MSS and Rs 5,500 crore of treasury bills under MSS. These auctions will see the markets bidding for tails in the auctions.

Liquidity as measured by bids for reverse repo/ repo in the LAF (liquidity adjustment facility) of the RBI increased sharply as the RBI currency intervention added liquidity into the system.

Bids for reverse repo at 6% were over Rs 50,000 crore. Overnight rates hovered around reverse repo rates of 6%.

Overnight rates are expected to remain at around 6% levels given the current liquidity in the system.

Government bonds

Government bond yields closed mixed week on week. The yield on the benchmark ten year bond 7.99% 2017 bond ended flat last week at 7.91% levels.

Five-year benchmark bond yields closed lower by 4 bps, with the yield on the 7.40% 2012 bond closing at 7.76% levels. Yields on the long bond the 8.33% 2036 bond closed higher by 1 bps at 8.43% levels.

The five over thirty segment of the curve steepened by 5 bps to close the week at 67 bps levels.

The RBI held government bond auctions under MSS last week. The bonds auctioned were the 5.87% 2010 bonds for Rs 4,000 crore and the 11.30% 2010 bonds for Rs 3,000 crore. The auctions saw cut offs at 7.80% and 7.84%, respectively.

The ample liquidity in the system saw the auctions through without any distortion in yields.

The coming week will see the RBI auctioning bond under the government borrowing program for the second half of fiscal 2007-08. The bonds to be auctioned are the 7.99% 2017 bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore.

The RBI is also auctioning Rs 4000 crore each of 5.87% 2010 bonds and 11.30% 2010 bond under MSS. Tails are expected to be long in the auctions.

T-bills, corporate bonds and overnight index swaps

Treasury bills (T-bills) yields at the short end came off last week on the back of higher system liquidity. The cut-off on the 91-day T-bill auction held on the October 3 came in at 7.14% against a cut off of 7.19% seen in the week earlier to last.

The 184-day T-bill auction saw the cut off coming in at 7.32% against 7.25% seen in the previous auction. The RBI is auctioning Rs 3,500 crore of 91-day and Rs 3,000 crore of 364-day T-bills this week including Rs 3000 crore of 91-day and Rs 2,000 crore of 364-day T-bills under MSS.

Corporate bonds saw spreads move down as investors bought into higher spreads. The five year AAA bond yield was quoting at 9.50%-9.55%, down 10 bps week on week.

The five year AAA spreads were lower by around 11 bps at 169 bps levels. Credit spreads may not sustain at current levels given the liquidity sucking measures by the RBI.

Overnight index swaps (OIS) saw yields come off on higher system liquidity The one-year OIS yield fell 5 bps to close last week at 7.03% levels.

The five-year OIS yield closed down by 1 bps at 7.27% levels. The one over five spread closed at 23 bps higher by 4bps week on week. Swaps will look to move higher on interest rate worries.

The author is head, portfolio management services, Sundaram BNP Paribas AMC Ltd. The views expressed by the author are his own and need not represent the views of the organisation in which he works.