Oil on boil, market may revisit yields

The enthusiasm of markets on January 2012 inflation coming in below 7% is going away with the spurt in oil prices.

Bond yields are trading at close to 10-month lows, with the 10-year benchmark government bonds yield hovering around 8.20% levels. And if oil prices stay high at current levels of $125/bbl on brent crude, the yields will move up steadily, post the RBI policy review on March 15.

Bond markets will not go really bearish into the policy review in March despite high oil prices as the RBI is likely to cut the cash reserve ratio (CRR) by 50 bps to ease system liquidity. Liquidity as measured by bids in the Liquidity Adjustment Facility (LAF) of the RBI saw bids for repo average Rs1,38,000 crore on a daily basis last week. March is the fiscal year end where demand for funds by the system is heavy. March will also see the fourth quarter advance tax moving out of the system, and if the tax outflow does not come back on the back of government spending, liquidity situation could get worse.

Bids for repo are likely to average over Rs1,50,000 crore on a daily basis in the next few weeks.

Rising oil prices are a huge headache to the government and the RBI. The government is unable to pass on the rising oil prices to the end user due to lack of political will, and this inability is translating into a burgeoning subsidy bill.

This fiscal subsidy bill is likely to overshoot the Budget target by over Rs1,00,000 crore. The rising subsidy bill is being funded by market borrowings rather than by higher revenue in the form of tax collections. The government will have borrowed the most on record in a single year when it finishes 2011-12 borrowing programme in March 2012. The borrowing will touch Rs5,10,000 crore this year after the last auction of Rs12,000 crore is completed in March.

The RBI faces two issues due to rising oil prices. The first issue is inflation is understated to the extent that rising global oil prices are not passed on to the end user.

RBI cannot make realistic forecasts on inflation to set its monetary policy stance, given the uneven pass-through of oil prices into the economy. The second issue the RBI faces is that it is forced to absorb part of rising government borrowing that arises out of funding the subsidy bill.

The RBI has bought over Rs100,000 crore of government bonds this fiscal, the highest on record, and while the central bank may claim the bond purchases were in order to ease liquidity, the fact is that it is undertaking an inflationary activity. Hence, rising oil prices impact monetary policy and the policy may actually go against RBI’s internal stance.

Money market yields rose on the back of tight liquidity conditions. One-year benchmark CD (Certificate of Deposits) yields moved up by 10 bps to close at 10.15% levels. Corporate bond yields at the short end of the yield curve will remain pressured due to tight liquidity conditions expected in March.

The interest rate swap curve moved up week on week on the back of rising oil prices and tight liquidity conditions. One-year overnight index swaps (OIS) yields went up 8 bps and 5-year OIS yields rose 11 bps to close at 8.17% and 7.44% levels, respectively. The OIS curve will remain pressured due to expected liquidity tightness in March.

Government bond auctions
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 8.19% 2020 for Rs3,000 crore, the 9.15% 2024 bond for Rs6,000 crore, and the 8.97% 2030 bond for Rs3,000 crore.

The cut-offs came in at 8.30%, 8.31% and 8.59%, respectively. The government has one more auction left for this fiscal, which is scheduled for March 9.

The RBI bought Rs11,840 crore of bonds last week in its bond purchase auction. The bonds purchased were the 8.79% 2021 bond for Rs8,314 crore at 8.20%, the 8.28% 2027 bond for Rs3210 crore at 8.50% and the 8.28% 2032 bond for Rs314 crores at 8.51%.

The writer is editor of
www.investorsareidiots.com,
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