Comment

However, liquidity remains a concern

The outlook for interest rates is becoming clearer, with many of the factors that drove yields higher turning positive. More importantly, the ‘surprise factor’ that spooked markets into driving up yields is not as prominent. The only outlier in the clearer picture for interest rates is the liquidity factor.

However, while interest rates do look positive, the outlook for credit spreads, which have been steadily moving up, is highly negative.

The global credit crisis has brought down commodity prices, a key driver of inflation. Oil prices, which had touched highs of $145/ barrel, are at $94/bbl levels, 35% down from highs. Copper prices are down 30% from peaks. The steep fall in commodity prices is indicating a sharp slowdown in growth. This is good for inflation as well as interest rates. Inflation expectations will come down, prompting central banks across the world to cut interest rates to spur slowing economic growth.

Domestic inflation is showing signs of slowing down. Inflation as measured by the wholesale price index (WPI) came in at 11.99%, for the week ended September 20, 2008, as against market expectations of 12.14%. Inflation had gone as high as 12.63% in August 2008. The rate is expected to remain at double-digit levels till the end of this calendar year; however, inflation expectations have been coming down with the steep falls in commodity prices.

The government has made statements that it could exceed the borrowing targets set for this fiscal. It is expected to borrow Rs 25,000 crore more than the budgeted borrowing of Rs 49,000 crore in the October 2008-March 2009 period. The government has also indicated that it is expecting the Reserve Bank of India (RBI) to maintain status quo on policy rates at the central bank’s policy meet in October. While the RBI will act independently, expectations of rate hikes are coming off on the back of the global economic worries.

The worry in the market is liquidity. The pressure on the rupee, which has fallen 17% year to date, is forcing the RBI to step in and sell dollars. This is placing high pressure on the system, with the market accessing RBI repo window for funds for Rs 90,000 crore. The weakness in equity markets is seeing portfolio outflows, putting further pressure on the rupee. The RBI has options to cut SLR (statutory liquidity ratio) or CRR (cash reserve ratio) or both. The market is widely expecting RBI to cut CRR to ease strains on liquidity.

The liquidity tightness is placing high pressure on corporate borrowers, with yields on short-end papers (one year and lower maturities) shooting up to 12.50% plus levels. This is leading to negative sentiments on credits, placing further weakness in credit spreads. The global events on credits with failures of large banks, has worsened the outlook for credits.

Liquidity was tight last week with the LAF (liquidity adjustment facility) auction seeing bids for repo at 9% touching Rs 90,000 crore. Overnight rates held at 15% levels. Liquidity is expected to be tight this week though repo bids may come off if demand for products decreases in the reporting week.

Government bonds: Giltssaw yields move down week on week. The benchmark ten-year bond yield closed the week higher by 28 basis points (bps), with the 8.24% 2018 bond closing the week at 8.29% levels. The auction stock, the 7.94% 2021 bond, saw yields move down by 26bps week on week to close at 8.77% levels. The fall in oil prices and increasing expectations of RBI maintaining status quo on policy pushed yields down.

The government has announced government bond auctions for Rs 10,000 crore. The bonds to be auctioned on October 10 are a new six-year bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore. The six-year bond will be auctioned on a yield basis. The auctions are expected to sail through, though primary dealers may have to sell down existing stock to fund the auction bids, given liquidity tightness.

Treasury bills, corporate bonds and overnight index swaps: Treasury bill (T-bills) yields were higher last week. The cut-off on the 91-day T-bill auction held on October 1 came in at 8.86% against a cut-off of 8.56% in the previous week. The 182-day T-bill auction saw the cut-off coming in at 9.01% against a cut-off of 8.77% in the previous auction. The RBI, this week, is auctioning Rs 5,000 crore of 91-day T-bills and Rs 2,000 crore of 364-day T-bill under regular auction.

Corporate bonds saw yields moving higher even as government bond yields fell. Ten-year benchmark AAA yields were higher by 10bps at 11.10% to 11.20% levels, while ten-year benchmark bond spreads were higher by 32bps at around 264bps levels. The short end of the curve saw yields move up sharply, with one-year benchmark bank certificate of deposit yields moving higher by 75bps at 12.50% levels. Corporate bonds yields are likely to be pressured on liquidity and supply worries.

Overnight index swap (OIS) saw yields come off on positive interest rate sentiments. The five-year OIS yield came off by 37bps to close at 7.87% levels and one-year OIS yield closed 2bps lower at 8.85% levels. The one-over-five spread inverted by 25bps to close at 95bps levels. The curve is likely to maintain high inversion spreads given the high call money rates.

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