Comment

Oil, inflation and govt’s fiscal woes likely to push up yields

The bond market was hit by a double whammy of rising inflation and supply pressures last week. The government last week hiked oil prices, which is expected to add 60 basis points (bps) to inflation numbers in the coming weeks.

Economists are predicting double digit inflation in the near future on the back of oil-price effects and its pass through to other essential commodities.

The government also cut taxes on petroleum products, which will hit its revenues by Rs 22,000 crore. The market fears that this will translate into additional borrowing by the government.

Adding to fiscal pressures is the Rs 96,000 crore of oil bonds that the government will have to issue to oil companies to compensate for their losses. The oil bonds are not likely to have direct impact on supply as the Reserve Bank of India (RBI) is transacting directly with oil companies to swap the bonds with US dollars.

However, indirect effects are higher interest costs to the government and increased borrowing as the bonds mature. The Rs 71,000 crore loan waiver programme will also add to the government’s fiscal woes.

Oil last week closed at over $137 barrel with Nymex crude futures spiking 8% on the last day of last week as US unemployment rate jumped to 5.5% against expectations of 5.1%.

The negative US non-farm payroll numbers gave rise to fears of a US recession and of dollar weakness, leading to the jump in oil prices.

The domestic inflation numbers as measured by the wholesale price index (WPI) came in at 8.24% for the week ended May 24, 2008. The RBI sounded extremely hawkish on inflation, saying that the levels are unacceptable and it will use all tools at its disposal to temper inflation expectations. The market took this as hints of rate hikes.

Benchmark ten-year bond yields rose 15 bps week-on-week to close at 8.24% levels. The bond had seen such levels before the RBI annual policy on April 29, 2008.

The markets had then expected rate hikes in the policy which the RBI refrained from doing.

Yields had come off by 40 bps post policy as markets unwound shorts. The pre policy levels of yields, coupled with negative interest factors of oil, inflation and government finances, are likely to put further pressure on yields.

Liquidity, as measured by bids for reverse repo repo in the liquidity adjustment facility (LAF) of the RBI, was easy last week, with bids for reverse repo touching Rs 29,000 crore.

The banks were well covered on their products in the reporting week. Liquidity is likely to come off in the new reporting fortnight beginning June 7, 2008. Overnight rates were easy at below 6% levels but are likely to trend higher as liquidity conditions tighten.

Government bonds
Government bonds yields rose sharply week on week. The ten-year bond yield closed higher by 15 bps, with the benchmark 8.24% 2018 paper closing the week at 8.25% levels. Five-year benchmark bond yields were higher by 21 bps, with the yield on the 7.27% 2013 bond closing at 8.26% levels.

Yields on the long bond, the 8.33% 2036, closed higher by 22 bps at 8.67% levels. The ten over thirty spread closed higher by 7 bps at 42 bps levels while the five over ten spread inverted to 3 bps.

The government held dated bond auctions for Rs 10,000 crore on June 6. The auction was as per the schedule given in the government borrowing calendar for the first half of fiscal 2008-09. The bonds auctioned were the 8.24% 2018 bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore.

The cut-offs came in close to market expectations. The 8.24% 2018 bond auction cut-off came in at 8.24% while the 7.95% 2032 bond auction cut-off came in at 8.72% levels. The market covered their shorts in the auction leading to lack of a tail.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bills) yields at the short end were higher last week. The cut-off on the 91-day T-bill auctioned on June 4 came in at 7.56% against a cut-off of 7.48% seen in the previous auction.

The 364-day T-bill auction saw the cut-off coming in at 7.61% against a cut-off of 7.66% seen in the previous auction. The RBI is auctioning Rs 3,000 crore of 91-day T-bills and Rs 500 crore of 182-day T-bills under regular auction this week.

Corporate bonds saw yields move higher on interest rate and liquidity worries though spreads came off as yields turned sticky at higher levels. Five-year yields were trading in the 9.70% to 9.75% range, up by 15 bps week on week. Five-year AAA bond spreads were lower by 6 bps week on week at 132 bps levels.

Overnight index swaps (OIS) saw the curve move up sharply on interest rate worries. One-year OIS yields moved up by 21 bps to close last week at 7.90%% levels while the five-year OIS yields closed higher by 25 bps at 8.20% levels. The one-over-five spread steepened by 4 bps week on week to close at 30bps levels.

The curve saw profit taking at higher levels with five year OIS coming off from highs of 8.40% levels. OIS yields are likely to remain pressured on interest rate worries.

Crude hit
Tax cut on petroleum products, issue of oil bonds, farm loan waiver to deteriorate the government’s fiscal situation

Overnight rates are likely to trend higher as liquidity conditions tighten

Overnight index swaps yields are expected to remain pressured on interest rate worries

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