Comment

Any increase in government’s borrowing will push up bond yields

The market is now discounting repo and reverse repo rate cuts by the Reserve Bank of India (RBI) on the back of a sharp fall in inflation and a faster-than-expected slowdown in economic growth.

The ten-year benchmark bond yield closed the week at 7.19% levels, down 25 basis points (bps) week-on-week. The bond is now trading at levels seen a couple of years ago. The overnight index swap (OIS) curve closed below 5.5% levels and is discounting a 25 to 50 bps cut in the reverse repo rate.

The rate-cut speculation is fuelled by governmentspeak on monetary easing, with the finance minister and the Prime Minister’s Economic Advisory Panel calling for lower interest rates to spur economic growth.

The surrounding macro environment is positive for rate cuts. GDP growth forecasts for the Indian economy have come off sharply, from 8.5% levels to 7% levels. A few economists are expecting below-7% numbers.

Inflation has also come off from highs of over 12.5% seen in August 2008 to levels of 8.90% in November 2008. Inflation is expected to go below RBI’s fiscal-end target of 7% on the back of a sharp fall in commodity prices.

Oil prices are off by 65% from highs of $145/barrel to levels of $50/barrel. They are expected to remain pressured on the back of global demand destruction. The market is now staring at disinflation brought about by a sharp reduction in commodity prices and lack of pricing power by corporates in the economy.

On the global front, the Eurozone and Japan are already seeing recession while the US, UK and other large economies are expected to go into recession in the next couple of quarters. China, the world’s fastest-growing economy, is seeing a sharp slowdown in growth, from double-digit levels to 7-8%. Global central banks have signalled further rate cuts, with the worry now being depression rather than just a couple of quarters of recession.

The conditions for lower interest rates and lower bond yields are firmly in place. The only disturbing factor is the pump-priming talk of the government. The government is expected to throw away fiscal deficit targets (pegged at 2.5% of GDP) in the face of sharp slowdown in growth. Its fiscal deficit, including off-balance sheet items, is over 5.5% of GDP and any further increase will put pressure on its finances. The market is worried about the extent of higher government borrowing for the fiscal 2008-09. The government has completed its borrowing programme for the fiscal and any borrowing from here is additional. The announcement of additional borrowing will tend to take bond yields up, but will give a good entry point for players given the forecast of lower interest rates going into fiscal 2009-10.

Liquidity was easy last week with bids for reverse repo at 6% crossing Rs 25,000 crore. Overnight rates moved down on easy liquidity, with call rates trading at 6% to 6.5% levels from 7.5% levels. Liquidity is expected to be neutral this week though it may go into negative if RBI had sold dollars aggressively to stem currency volatility.

Government bonds
Government bonds saw yields move down week on week. The benchmark ten-year bond yield closed the week lower by 26 bps, with the 8.24% 2018 bond closing at 7.19% levels. The five-year benchmark bond, the 7.56% 2014, closed down 20 bps week- on-week. The yields on the long bond, the 7.95% 2032, moved down by 40bps week-on-week to close at 7.72% levels. The government bought back market stabilisation (MSS) bonds for Rs 9,000 crore last week. The bonds bought back were the 5.87% 2010 for Rs 4,000 crore and the 7.55% 2010 bond for Rs 5,000 crore. The government bought the bonds back at yields of 6.61% and 6.71%, respectively.

The government held bond auctions for Rs 9,000 crore last week. The bonds auctioned were the 7.56% 2014 for

Rs 6,000 crore and the 7.94% 2021 bond for Rs 3,000 crore. The cuts-off came in at 7.16% and 7.41%, respectively.

Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bill (T-bills) yields were lower at the auction last week, with the cut-off at the 91-day paper coming in at 7.31% against a cut-off of 7.35% in the previous week.

The 364-day T-bill auction saw the cut-off at 7.09% against a cut-off of 7.21% in the previous auction. The RBI isauctioning Rs 5,000 crore of 91-day T-bills and Rs 2,000 crore of 184-day T-bills under regular auction this week.

Corporate bonds saw primary issues keeping yields in check. Power Finance Corporation issued 10-year bonds at 11.25% while Reliance placed 5-year bonds at 11.45%. The spreads were at 385 bps and 400 bps, respectively. Credit spreads are likely to be pressured on the back of supply expectations and lack of liquidity for corporates, both in the domestic and global markets.

The OIS curve fell on expectations of a cut in the reverse repo rate. The five-year OIS yield closed down 80 bps at 6.50% levels and one-year OIS yield closed down 50 bps at 5.30% levels. OIS yields are likely to stay bullish given rate cut expectations.

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