Quantum of debt gives market the blues

Bond markets had a bad week with both Reserve Bank of India (RBI) and the government delivering bad news. Bond yields rose 14 basis points (bps), with the 10-year benchmark bond, the 8.79% 2021 bond yield closing at calendar year highs of 8.42%.

The outlook for bond yields is negative in the near term as markets digest the bad news, but going into April, yields will move down on easing liquidity conditions and hopes of repo rate cuts by the RBI in its April 2012 annual policy meet.

RBI refrained from reducing the repo rate in its policy review on March 15, citing latent inflationary pressures due to administered prices and the government’s inability to contain its fiscal deficit. Worries on whether the RBI will delay reducing rates in fiscal 2012-13 prompted markets to start factoring in lower-than-expected quantum of rate cuts. Bond yields gave up some ground on the back of market worries on RBI easing its policy in the next fiscal.

The government too delivered a blow by announcing higher-than-expected borrowing for 2012-13, with gross borrowing at `5,69,000 crore against market expectations of `5,50,000 crore. Ten-year bond yields reacted negatively to this with yields rising by 8 bps post the announcement. Bond markets were not too enthused by the lower fiscal deficit projections of the Budget at 5.1% of GDP against revised fiscal 2011-12 estimates of 5.9% of GDP. The market is worried about the quantum of borrowing and its demand-supply equations rather than relative fiscal deficit ratios.

Index of Industrial Production (IIP) growth for January 2012 was  higher than market expectations at 6.8% while inflation for February 2012 came in at 6.95%, also higher than market expectations of 6.75%. Economic data did not favour bond markets, adding to poor market sentiment.

Last week, liquidity as measured by bids for repo in the liquidity adjustment facility tightened by `24,000 crore week on week. Advance tax outflows negated the release of `48,000 crore of liquidity through a 75 bps cash reserve ratio (CRR) cut that came into effect last week. Liquidity will continue to remain tight next fortnight due to fiscal year-end demand for money by the system. Money market securities rates stayed at higher levels despite the CRR cut with three month Certificate of Deposit (CD) rates at 11.5% levels and one-year CD rates at 10.95% levels. CD yields will trend downward in the last week of March, as the outlook for April liquidity spurs buying at higher levels of yields.

Interest rate swaps saw the curve trending higher on the back of rising government bond yields and disappointment over policy rates staying status quo. One-year OIS yields moved higher by 5 bps and five-year OIS yields moved up 15bps week on week. The five over one segment of the OIS yield curve gave up some of its inversion, with the spread coming off by 10 bps to close at negative 59 bps levels.

The OIS yield curve will give up more of its inversion in coming weeks on the back of expectations of easing liquidity in April.