Comment

The bond market is expected to trade circumspect in the coming weeks on uncertainty on the direction of interest rates.

The interest rate cut by the US Federal Reserve (Fed cut the benchmark Fed funds rate by 50 bps earlier this month) has sparked off inflationary fears due to rising commodity prices on the back of dollar weakness and due to large liquidity flows driving up asset prices.

This has placed the RBI (Reserve Bank of India) in a fix, as on one hand inflation and financial market stability are threatened by Fed actions, while on the other hand worries of a US-led slowdown may slow emerging markets growth.

The RBI has been steadily issuing MSS (market stabilization scheme) bonds to take out excess liquidity in the system that is arising from liquidity flows. Continued weakness in dollar leading to large liquidity flows may force the RBI to take further measures such as a hike in the CRR (cash reserve ratio).

Bond yields rose last week on the back of uncertainty in the market on the direction of interest rates.

Trader selling coupled with investor absence saw yields move higher by 10 bps, with the 10-year benchmark bond closing the week at 7.91% levels from 7.81% levels seen in the week before last.

Interest rate swaps saw yields close 20 bps higher week on week, as increased paying interest coupled with profit taking at lower yields saw traders cut their received positions.

This will see the RBI auctioning Rs 12,000 crore of dated bonds and treasury bills under MSS. The RBI has also released the government borrowing calendar for the second half of fiscal 2007-08.

October will see government bond auctions of Rs 18,000 crore,with Rs 10,000 crore scheduled between 5th and 12th of October.

The MSS auctions, coupled with government bond auctions, will keep the markets nervous.

Liquidity as measured by bids for reverse repo/ repo in the LAF (Liquidity Adjustment Facility) of the RBI swung from positive of over Rs 20,000 crore to negative of around around Rs 6,000 crore during the week.

Liquidity is likely to be under pressure on auction outflows and this will keep overnight rates higher.

Government bonds
Government bond yields closed higher last week on the back of interest rate uncertainty. The yield on the benchmark ten year bond 7.99% 2017 bond closed last week at 7.91% levels from 7.81% levels seen in the week prior to last.

Five year benchmark bond yields closed higher by 13 bps with the yield on the 7.40% 2012 bond closing at 7.80% levels.

Yields on the long bond the 8.33% 2036 bond closed higher by 6 bps at 8.42% levels. The five over thirty segment of the curve flattened by 6 bps to close the week at 62 bps levels.

The RBI has announced government bond auctions under MSS for this week.

The bonds to be auctioned are the 5.87% 2010 bonds for Rs 4000 crores and the 11.30% 2010 bonds for Rs 3000 crores. The auctions should see cutoffs coming in at higher levels of yields on increased supply.

T-bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields moved higher last week on the back of MSS auctions The cutoff on the 91-day T-bill auction held on the September 26 came inat 7.19% against a cutoff of 6.98% seen in the week earlier to last.

The 364 day T-bill auction saw the cutoff coming in at 7.50% against 7.47% seen in the previous auction.

The RBI is auctioning Rs 3,500 crore of 91-day and Rs 2,500 crore of 182-day T-bills this week, including Rs 3,000 crore of 91-day and Rs 2,000 crore of 364-day T-bills under MSS (market stabilization scheme)

Corporate bonds saw good primary supply at the one year maturity. Issuers lined up to issue one year paper at below 9% levels.

Five-year AAA papers were quoting at 9.65%-9.70% up 5 bps week on week. The five-year AAA spreads were lower by around 3 bps at 180 bps levels. Credit spreads are going to trend higher on the back of interest rate uncertainty coupled with high supply.

Overnight Index Swaps (OIS) saw yields rise on interest rate worries The one-year OIS yield rose 21 bps to close last week at 7.08% levels.

The five year OIS yield closed higher by 20 bps at 7.28% levels. The one over five spread closed at 19 bps . Swaps will look to move higher as MSS supply keeps levels firm at the short end..

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.