Comment

The bond market is starting to factor in a policy rate cut in the October 24 review of the annual monetary policy 2008-09.

The sharp change in sentiments over the last one month (there were expectations of a rate hike a month back) is due to the violent change in the domestic and global economic environment.

The sharp deterioration in economic conditions brought about by the credit crisis in global markets has forced the Reserve Bank of India (RBI) to cut the cash reserve ratio (CRR) and the statutory liquidity ratio (SLR) to infuse liquidity into the system. The RBI cut CRR by 2.5% from 9% to 6.5% releasing Rs 100,000 crore into the system. The SLR cut of 1.5% (albeit temporary) has released Rs 45,000 crore into the system.

The cuts in the liquidity ratio negated the liquidity crunch brought about by dollar outflows from the country. The foreign exchange reserves fell by $10 billion in the week to October 10, 2008, taking the total drop in reserves to $40 billion — from highs of $316 billion (in May) to levels of $275 billion now. The sharp drop of 50% in equities and 20% in the rupee in year to date has placed high pressure on the foreign exchange reserves.

The RBI has been selling US dollars to stem the volatility in the currency, placing pressure on liquidity. Hence, the cuts in liquidity ratios are not growth-inducing and the market is saying that policy rate cuts are required to send out growth signals to the economy.

The growth outlook for the economy is seriously threatened by the fear of recession in economies across the globe compounded by the liquidity freeze in global markets. Economists have reduced GDP growth numbers for 2008-09 by over 1% for India. The commodity markets are also factoring in recessionary trends with oil prices coming off by over 50% from highs and major commodity indices falling by over 30% from highs.

The fall in commodity prices has drastically reduced inflation expectations. Inflation is showing signs of trending down with inflation as measured by the WPI (wholesale price index) coming in at 11.44%, for the week ended October 4, 2008, as against market expectations of 11.46%. Inflation had touched highs of 12.78% in August 2008.

The threat to growth, reduced inflation expectations and global liquidity crunch is forcing policy makers across the globe to cut benchmark policy rates. The RBI had raised the benchmark repo rate by 125 basis points (bps) year to date to quell inflation expectations and the markets are looking at the RBI rolling back part of the hikes in its October policy review. However, RBI may wait for inflation to trend down below double digit levels before signaling preference to growth over reducing inflation expectations.

Liquidity eased last week. Liquidity as measured by bids for reverse repo/repo in the LAF (liquidity adjustment facility) auction saw bids for repo at 9% coming down to Rs 7,500 crore from highs of Rs 62,000 crore. The CRR cut of 2.5% released Rs 100,000 crore into the system. Overnight rates came off to 7% levels from 10% levels. Liquidity is expected ease this week as banks are well covered on their products and the government is releasing Rs 25,000 crore of farm loan waiver money to banks.

Government bonds
Government bonds saw yields move down week on week. The benchmark ten-year bond yield closed the week lower by 12 bps, with the 8.24% 2018 bond closing at 7.68% levels. The 7.94% 2021 bond saw yields move down by 5 bps week on week to close at 8.08% levels. The CRR cut, falling oil prices and lower inflation numbers helped bring down bond yields.

The government has announced bond auctions for Rs 10,000 crore. The bonds to be auctioned on October 20 are a new six-year bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore. The six-year bond will be auctioned on a yield basis. The auction cut-offs are expected to be bullish given the market expectations of rate cuts into the policy review.

Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bills (T-bills) yields were higher in the auction last week, with the cut-off on the 91 day T-bill auction held on October 15 coming in at 8.69% against a cut-off of 8.48% seen in the previous week. The 182-day T-bill auction saw the cut-off coming in at 8.68% against a cut-off of 8.77% seen in the previous auction. T-bill yields came off after the CRR cut to trade at below 8% levels. The RBI, this week, is auctioning Rs 5,000 crore of 91 day T-bills and Rs 2,000 crore of 364-day T-bills under regular auction.

Corporate bonds saw yields pressured despite CRR cuts, with ten-year benchmark bond yields hovering around the 11.50% levels. Yields at the short end of the curve came off from highs after the CRR cut and the announcement of 14-day repo window for banks to lend to mutual funds. Three-month benchmark certificate of deposit (CD) yields came off by 200 bps from highs on buying demand from banks. Corporate bonds yields are likely to be pressured on liquidity and supply worries.

OIS saw yields come off on positive interest rate sentiments. The five-year OIS yield came off by 34 bps to close at 6.90% levels and one-year OIS yield closed 57 bps lower at 6.80% levels. The one-over-five spread flattened by 31 bps. The spread steepened to 13 bps after being inverted for over two months. OIS yields are factoring in rate cuts and may see long unwinding after the policy review.

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