Comment

MUMBAI: The bond markets will react to movements in global crude oil prices, domestic liquidity and domestic inflation forecast this week.

Oil prices have reached dizzy heights and so has inflation. So much so, the market is factoring in double-digit inflation till the calendar-end. Liquidity is expected to be tight given that the Reserve Bank of India (RBI) is auctioning Rs 5,000 crore of treasury bills
(T-bills) at a time the market is accessing the central bank window for funds. The outlook for interest rates is weak and bond yields are likely to trend higher.

The market last week digested a lot of bad news with government bonds bearing the brunt of the weak sentiments. Oil prices spiked from the weekly low of $135/bbl to $145/bbl on geopolitical issues. Inflation as measured by the Wholesale Price Index came in at 11.89% for the week ended June 28, as against market expectations of 11.75%.

The market also contended with a threat of a sovereign rating downgrade by Standard & Poor’s (S&P), which cited high inflation, worsening government finances and slowing down of growth as reasons for a potential downgrade. Such a downgrade would be a sentiment driver rather than one with any potential economic impact since India does not have any sovereign external borrowings.

The 10-year government bond reacted to the bad news with yields spiking 30 basis points (bps) week-on-week. The bond closed at multi-year highs of 9.46% after crossing 9.50% levels during the week. The bond was late in reacting to inflation and the Reserve Bank of India’s (RBI) rate hike actions, and had outperformed interest rate swaps.

Five-year benchmark swaps are up 200 bps since their beginning in June 2006, while the 10-year bond has moved up by 120 bps in the same period. Last week saw the government bond catch up with the rest of the curve. Traders were loaded after the auction of Rs 6,000 crore of the benchmark 8.24% 2018 bond and scrambled to sell the bonds on negative interest rate outlook. The market grabbed a short uptick in sentiments to offload the bonds. The sentiments were boosted by a sharp fall in oil prices from $145/bbl to $135/bbl early last week as oil traders booked profits on longs.

On the global front, the Bank of England kept benchmark rates steady but indicated rate hikes to contain inflation expectations despite a weakening economy. This situation is applicable to the domestic front with the Index of Industrial Production data coming in at 3.8% against expectations of 6.5% for May. The high inflation number has the RBI focused on rate hikes to control inflation rather than look at growth.

Liquidity as measured by bids for reverse repo repo in RBI’s liquidity adjustment facility was tight last week, with bids for repo at 8.50% touching Rs 45,000 crore. Overnight rates traded around 9% levels on the back of tight liquidity. Liquidity is expected to remain tight and overnight rates are likely to hover around repo levels of 8.5%.

Government bonds
Government bonds saw yields spike as traders unloaded auction positions. The benchmark 10-year bond yield closed higher by 30 bps week-on-week with the 8.24% 2018 bond closing the week at 9.46% levels. Five-year benchmark bond yields were higher by 26 bps with the yield on the 7.27% 2013 bond closing at 9.52% levels.

Yields on the long bond, the 8.33% 2036 bond, closed higher by 30 bps at 9.75% levels. Bond yields are likely to remain pressured given negative interest rate sentiments.
T-bills, corporate bonds and overnight index swaps
Treasury bill yields were higher last week on the back of tight liquidity. The cut-off on the 91-day T-bill auction held on July 9 came in at 9.02% against a cut-off of 8.81% seen in the previous auction. The RBI accepted Rs 500 crore of the Rs 3,500 crore on auction. The 182-day T-bill auction saw the cut-off coming in at 9.34% against a cut-off of 9.16% seen in the previous auction.

The RBI, this week, is auctioning Rs 3,000 crore of 91-day T-bills, of which Rs 500 crore is under regular auction and Rs 2,500 crore is under the Market Stabilisation Scheme (MSS) and Rs 2,000 crore of 364-day T-bills, of which Rs 1,000 crore is under regular auction and Rs 1,000 crore is under MSS.

Corporate bonds saw yields steady at higher levels, bringing down credit spreads. Five-year bonds were trading flat at 10.70% to 10.80% levels. Credit spreads came off by 20 bps to close the week at 105 bps levels as government bond yields rose. Corporate bond yields may see supply pushing yields higher at the longer end.

Overnight index swaps (OIS) saw high volatility with yields moving 50 bps either way. One-year OIS yields moved down by 7 bps to close the week at 9.77% levels, while five-year OIS yields closed lower by 8 bps at 9.96% levels. OIS yields had gone down sharply at the beginning of the week with five-year OIS yields trading below 9.50% levels before coming back all the way to 10% levels. The OIS curve will see high volatility given the uncertain interest rate environment.

Disclaimer: The writer is senior fund manager - fixed income, IDFC Mutual Fund. Views are personal.