Comment

The bond market finally gave way to a host of interest rate-negative factors to break out of a tight range.

Ten-year bond yields closed last week at 7.86% levels, up 19 basis points (bps) week on week.

The yield had traded in a 7.50%-7.70% range over a two-month period. The upward trend is likely to persist till the Union Budget, which is to be presented to the Parliament on February 26, 2010.

The factors that will take yields up further are the higher-than-expected December 2009 industrial production growth, release of inflation data for January 2010, China’s second hike in cash reserve ratio in five weeks, and worries about the government borrowing programme for the next fiscal.

The Index of Industrial Production (IIP) growth for December
came in at 16.8%, which was higher than market expectations of around 12-13%.

The surge gives rise to concerns of a faster-than-expected rate hike by Reserve Bank of India as the government mulls withdrawal of stimulus.

Inflation (based on WPI or wholesale price index) for January will be released on February 15.

The trend in primary articles and fuel price inflation indicate that that number may well exceed market expectations of 8.2%.

The sharp rise in IIP growth foretells a higher trending manufacturing inflation. The sharp rise in fuel inflation index for the week ended January 30 from 5.9% to 10.4% week on week increases worries on mis-reporting of inflation in the previous weeks.

The rise in fuel price index was primarily contributed by coal mining index, which rose by 13.4% after having been shown as unchanged over the past many weeks.

The electricity index will also have to be increased sharply as there has been no change in the index for the past many weeks.

If the trend of numbers being increased sharply upwards continues, inflation may well cross double-digit levels in March.

China raised the cash reserve requirement of banks by 50bps for the second time in five weeks to cool a surging loan and property market. The hike will be viewed as cue for RBI to follow suit quickly, especially as India’s IIP and inflation numbers are way above forecasts.

RBI has indicated that the government may borrow as much or even higher in the next fiscal than the Rs 450,000 crore raised from the market in this fiscal.

The central bank has expressed its concern about managing the borrowing program given that some of the liquidity tools such as market stabilisation scheme bonds desequestering and open market operation bond purchases may not be available to the extent they were in this fiscal.

The RBI, in expressing concerns over managing the government borrowings, has indirectly indicated that it will not be looking to cool down yields given the higher trending inflation expectations and high levels of market borrowings by the government.

Liquidity
Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of the RBI came off week on week as banks parked more cash with RBI in the reporting week. Bids for reverse repo (at 3.25%) were at Rs 70,000 crores against Rs 120,000 crores seen in the week before last. Liquidity is likely to tighten as the first tranche of cash reserve ratio (CRR) hike of 50bps comes into effect this week. The CRR hike will impound Rs 24,000 crores from the system.Overnight rates were at reverse repo levels of 3.25% and may see some pressure on liquidity tightening worries.

Government bonds
Government bonds saw yields move up across the curve on
inflation, rate hikes and government borrowing worries. The ten-year benchmark, the 6.35% 2020 saw yields close at 7.86% levels, up 19 bps week on week, while the five-year bond, the 7.32% 2014, saw yields close up 11 bps at 7.28%.
The 7.02% 2016 saw yields rise 16bps at 7.66%, while yields on 8.24% 2027 closed higher by 10 bps at 8.37% levels. Government bond yields are likely to be pressured on rate hike and government borrowing worries.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills yields were flat in the auction of 91-day paper on
February 9, with the cut-off coming in at 4.09% against a similar cut-off at the previous auction. The 364-day bill auction saw the cut-off at 4.88% against 4.70% seen in the previous auction. The RBI is auctioning Rs 5,000 crore of 91-day bills and Rs 1,500 crore of182-day paper this week.

Corporate bonds saw yields rise across the curve. One-year certificate of deposit (CD) rates rose 25 bps to close at 6.5% levels, while three-year corporate bonds saw yields up 15bps to 7.75% levels.

Five- and ten-year corporate bonds yields moved up by 10bps to close at 8.5% and 8.8%, respectively. Five- and ten-year credit spreads closed down by 10 bps at 109 bps and 80bps, respectively. Credit spreads are likely to move up on the back of liquidity, rate hike and regulation impact (base rate rule laid down by the RBI) worries.

Overnight index swaps (OIS)
saw the curve move higher week on week. The five-year OIS yield closed higher by 7 bps at 7.12% levels, while the one-year OIS yield closed up 5 bps at 4.98% levels. The one-over-five spread closed up 2bps at 214 bps levels. OIS curve is likely to remain pressured on worries of interest rate hikes.

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