Comment

The 10-year benchmark bond yield fell below 5.50%, close to the all-time low of just below 5%, seen five years ago.

The reverse repo rate was at 4.5% at the time when the ten year bond yield touched all time lows of 4.95%.

The reverse repo rate is currently at 5% after the Reserve Bank of India cut the rate by 100 basis points on December 5. The market expects RBI to cut the rate by at least 50bps more before their policy review in January 2009.

The reverse repo rate cut could be steeper than expected. RBI can cut the reverse repo rate by 100bps to signal lower interest rates and send out a strong pro-growth monetary policy stance.

The central bank is aided by many factors in taking aggressive policy measures.

The first is inflation, which is now looking to print at 0% in calendar 2009. Inflation as measured by the wholesale price index came in at 6.84% for the week ended December 6, against market expectations of 7.5%. The sharp fall in the WPI as well as global commodity prices is expected to impact inflation positively.

The government may cut fuel prices on the back of oil prices hovering around $40/bbl and this would further improve inflation sentiments.

The second factor is the record low levels of interest rates for major world economies.

The US Federal Reserve cut benchmark rates by at least 75bps last week, while the Bank of Japan cut rates by 20bps. The policy rate for the US is now targeted in the 0-0.25% range, while that for Japan is at 0.10%.

Treasury yields have fallen to all-time lows in the US on deflation fears. The European Central Bank is also expected to bring down euro-zone policy rates to all-time lows on recession fears.

China is expected to cut rates this week to spur a flagging economy. The all-time lows of global interest rates is a strong factor for RBI to act aggressively on policy rates.

The third factor for RBI to act on rates is the fiscal stimulus required to pump up the economy. The government would have to borrow to fund the stimulus package, and it will want interest rates to be low, so as to reduce its cost of borrowing. The government is borrowing an additional Rs 45,000 crore this fiscal, and incremental borrowing costs will go down on the back of aggressive rate cuts.

Meanwhile, liquidity stayed positive last week despite advance tax outflows.

Overnight rates were trading in a 5-6.5% range, with the RBI seeing bids for both reverse repo and repo in the liquidity adjustment facility auction. Liquidity is expected to be tighter this week on the back of fresh product covering by banks and on traditional quarter-end demand for money. Overnight rates are expected to be in the 5-6% band.

Government bonds
Government bonds saw yields move down week-on-week. The benchmark 10-year bond yield ended lower by 70bps with the 8.24% 2018 bond closing at 5.52%. The benchmark five-year note, the 7.56% 2014 bond, closed down 61bps w-o-w at 5.64%. The long bond yield — for the 7.95% 2032 note — moved down by 38bps w-o-w to close at 6.57%. The ten-over-thirty spread steepened by 32bps to close at 110bps levels. Government bond yields are likely to stay positive given rate cut expectations.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were lower in the auction last week, with the cut-off on the 91 day T-bill auction on December 17 coming in at 5.45% against a cut-off of 5.65% in the previous week. The 364 day T-bill auction saw a cut-off at 5.36% against 6.30% in the previous auction. This week, RBI is auctioning Rs 500 crore of 91 day T-bills and Rs 500 crore of 182 day T-bills under regular auction.

Corporate bonds saw good activity on the back of a sharp fall in gilt yields. Ten-year benchmark AAA yields fell by 50bps to levels of 8.5%. The 10-year spreads, however, rose by 40bps to close at 300bps, given the sharp fall in gilt yields.

Five-year benchmark AAA spreads were steady at 285bps as the corporate bond yield curve flattened. Corporate bonds are likely to see good activity given primary issues and expected December-end demand from provident funds who will receive Rs 10,000 crore as interest payment on the Special Deposit Scheme.

Overnight index swaps (OIS) saw the curve fall on rate-cut expectations. The one year OIS yield moved down by 10bps to close at 4.60%, while the five-year OIS yield closed down 9bps at 4.79%. The one-over-five spread was unchanged over the week. The OIS curve will stay received on the back of rate cut expectations.

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