Comment

Liquidity to tighten as CRR hike kicks in, but govt bond redemptions to ease crunch

Bond markets are now looking beyond current macro-economic factors, given that most of the negatives are known and there aren’t too many surprises left to react to.

Bond yields fell sharply last week despite the rupee weakening, oil ruling at higher levels and inflation still high at 12.40%.

The market wanted a good rally and grasped the tight statutory liquidity ratio (SLR) levels of banks to take bond yields down. The banking system is at SLR levels of 27.5% against the mandatory 25%. The excess SLR is used to access the Reserve Bank of India (RBI) window for funds as well as for margining purposes. RBI has been supplying treasury bills to meet the SLR demand. However the market is turning positive on government bonds as expectations are the government bond supply will be absorbed easily by the system.

The 10-year benchmark bond rallied 36 basis points (bps) week-on-week on the back of the SLR story and on the back of the fact that the market was short.

The market was also helped by inflation numbers coming in lower than expected. Inflation as measured by the wholesale price index came in at 12.40%, for the week ended August 16, 2008, as against market expectations of 12.78%.

Oil has settled into $115/barrel to $120/barrel zone and market looks quite comfortable with oil at current levels. The rupee crossed the psychological Rs 44/$ mark on heavy demand from oil importers, which was overlooked by the market. The market behaviour shows that it is in a mood to look ahead and unless there are very negative surprises, the market is likely to be stable at lower levels of yields.

The first quarter GDP numbers for the current fiscal came in at 7.9%, which
was close to market expectations of 8%. However, the 7.9% growth is the lowest
in three years. The RBI in its annual report has sounded pessimistic on growth, citing the slowdown in the global economy.

The RBI also sounded a warning on inflation “at beyond tolerable levels”. However, given that the RBI has raised policy rates, elevated inflation expectations may look to come down.

Government finances are also causing concern on the back of subsidies, loan waivers and pay commission hikes. However, auction of 3G licences (estimated at Rs 30,000-40,000 crore) can mitigate some pressure. The market at this point of time is not factoring in higher-than-budgeted borrowings by the government.

Liquidity as measured by bids for reverse repo rate in the liquidity adjustment facility (LAF) eased last week as the system was well-covered on products. Bids for repo at 9% came off from Rs 20,000 crore to Rs 8,000 crore. Overnight rates came off from 9% levels to 6% levels as liquidity eased.

Liquidity is likely to tighten with the kicking-in of the 25 bps cash reserve ratio (CRR) hike, which will take out Rs 9,000 crore from the system, and on fresh product covering by banks. However, inflows through government bond redemptions are likely to ease pressure on liquidity. Overnight rates are likely to hover around repo levels.

Government bonds: Government bonds saw yields move lower week-on-week, as the market took hold of the short SLR story. The benchmark 10-year bond yield closed the week lower by 36 bps, with the 8.24% 2018 bond closing the week at 8.71% levels. The newly auctioned bond, the 8.24% 2027 bond, saw yields fall 23 bps to 9.63% from 9.86% levels. The spread between the 10-year and the 19-year bond is at 92 bps levels. The spread may come off if the 10-year bond stabilises at lower levels of yields.

Treasury bills, corporate bonds & overnight index swaps (OIS): Treasury bill (T-bill) yields were down last week with the cut-off on the 91-day T-bill auction held on August 27 coming in at 9.06% against a cut-off of 9.15% seen in the previous week. The 364-day T-bill auction saw the cut-off coming in at 9.18% against a cut-off of 9.29% seen in the previous auction. The RBI, this week, is auctioning Rs 5,000 crore of 91-day T-bills, of which Rs 3,000 crore is under regular auction and Rs 2,000 crore under the Market Stabilisation Scheme (MSS) and Rs 2,500 crore of 182-day T-bills of which Rs 500 crore is under regular auction and Rs 2,000 crore under MSS.

Corporate bonds saw yields remaining at higher levels on the back of primary supply. Ten-year benchmark AAA yields were at 10.95% to 11% levels. One-year benchmark bank certificate of deposits were quoted flat at 11.30% levels. Credit spreads moved up sharply as corporate bonds did not follow the government bond rally. Credit spreads as measured by the spread between 10-year benchmark AAA paper and the 10-year government bond moved up by 50 bps to close at 210 bps levels. Corporate bond yields are likely to remain pressured on supply and liquidity issues.

OIS saw the one-over-five spreads move up sharply as the five-year OIS yield moved down following government bond yields, while the one-year OIS yield moved up on liquidity fears. The one-over-five spread inverted by 28 bps to close last week at 44 bps levels. Five-year OIS yields came off by 18 bps to close at 9.05% levels, while one-year OIS yields closed higher by 10 bps at 9.49% levels. The yield curve is likely to remain inverted given the interest rate and liquidity outlook.

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