Comment

Likely Fed rate cut , lower inflation are positives for local interest rates

The news flows for interest rates in the last week have been positive and this will keep the market sentiments firm in the near term. The US non-farm payroll number for August 2007, dropped to negative 4000, the first drop in four years. The market expected 1,00,000 jobs to be added and instead saw 4,000 jobs being cut.

The US treasuries rallied sharply (by 12 bps) after the data release on Friday, with the ten year note closing the week at 4.38% levels. The ten year note saw yields drop 16 bps week on week. The two year note fell below 4% after the data release. The two over ten yield curve, which was inverted for a long period of time (over two years), has now steepened by 50 bps. This indicates a strong probability of a US Federal Reserve (Fed) rate cut as the US economy threatens to go into recession after the mortgage bust and housing market collapse.

A Fed rate cut is positive for interest rates globally, as signals of US recession are negative for economic growth across the globe. The RBI (Reserve Bank of India) factors in rate actions by global central banks for framing its monetary policy. The ongoing credit market turmoil has forced central banks in Australia, UK and EuroZone to maintain status quo on interest rates. The RBI will also now be expected to keep policy rates steady on the back of global signs of growth slowdown.

The other factors that are interest rate positive are the lower headline inflation numbers and other macro aggregates. The headline inflation as measured by WPI (wholesale price inflation) came in at 3.79% for the week ended August 25, 2007. This is against RBI’s (Reserve Bank of India) fiscal year 2007-08 target of around 5%. Money supply growth (M3) was at 20% as of August 17, 2007, against 21.7% seen a fortnight ago.

Credit growth was at 23.1% as of August 17, which is around RBI ‘s target levels for the fiscal. Domestic liquidity is good with bids for reverse repo at over Rs 35,000 crore. The cut-off on the 15-year bond auction came in 5 bps above expectations. The rally in bonds globally, coupled with positive domestic interest rate factors, will keep sentiment firm in the bond markets.

The negatives are in the form of potential portfolio outflows on the back of a perceived global recession. High oil prices and high ex-fuel inflation are also interest rate deterrents. The demand for credit can go up if domestic corporates are unable to access outside funds due to credit market turmoil. The higher demand for credit will push up rates given that the government is a large borrower in the domestic markets. However, the negatives will be overlooked in the short term as markets clamour for a Fed rate cut.

Liquidity as measured by bids for reverse repo in the LAF (liquidity adjustment facility) of the RBI was good, with bids of over Rs 35,000 crore. The overnight rates were at around the reverse repo rate of 6%. Liquidity is expected to be stable even after advance tax outflows post September 15.

Government bonds
Government bond yields were lower week on week on the back of positive interest rate news flows. The yield on the benchmark ten year bond 7.49% 2017 bond closed last week at 7.88% levels, lower by 4 bps week on week. Five-year benchmark bond yields were down 10 bps, with the yield on the 7.40% 2012 bond closing at 7.71% levels. Yields on the long bond the 8.33% 2036 bond closed higher by 4bps at 8.36% levels. The five over thirty segment of the curve steepened by 15 bps to close the week at 66bps levels.

The RBI held a government bond auction for Rs 7,000 crore last week. The bonds auctioned were the 8.20% 2022 bond for Rs 4,000 crore and the 8.33% 2036 bond for Rs 3,000 crore. The cut off on the 2022 bond came in at 8.15% against expectations of 8.20% while the long bond saw the cut off at 8.41% close to expectations of 8.40%. There are no government bond auctions scheduled for this month.

T-bills, corporate bonds, overnight index swaps
Treasury bills (T-bills) yields were lower last week on the back of good liquidity. The cut off on the 91 day T-bill auction held on September 5 came in at 7.06% against a cut off of 7.10% seen in the week before last. The 182-day T-bill auction saw the cut off coming in at 7.40% against 7.47% seen in the previous auction. The RBI is auctioning Rs 3,500 crore of 91-day and Rs 3,000 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.

Corporate bonds yields were steady, though spreads moved higher as government bonds rallied. Five year AAA papers were quoting at 9.75% to 9.80% levels. The AAA spreads were higher by 5 bps at around 190 bps levels. Credit spreads are going to trend higher as higher supply will keep yields flat while government bonds may rally on positive interest rate sentiments.

Overnight index swaps (OIS) saw yields drop on the back of positive interest rate outlook expectations. The curve did not change week on week. The one year OIS yield closed last week at 7.15% levels, down 15 bps week on week. The five year OIS yield closed down 15bps at 7.27%. The one over five spread closed at 11 bps. Outlook is positive for interest rate swaps as sentiments remain firm on interest rates.

The author is head, portfolio management services, Sundaram BNP Paribas AMC. The views expressed by the author are his own and need not represent the views of the organisation in which he works.