Comment

The bond market is likely to see a near-term rally on the back of a sharp fall in crude oil prices and a positive auction cut-off. The ten-year benchmark bond yield closed last week at 9.02% levels, down 27 bps week on week, and can potentially go down further.

Global crude oil prices fell sharply last week as the US dollar rallied against major currencies and oil demand forecasts were cut on signs of weakening global economies. Benchmark Nymex crude oil futures closed last week at $115 a barrel, down by $10 week on week. Lower oil prices tempers inflation expectations and places less pressure on government finances. Inflation as measured by the wholesale price index (WPI) was at 12.01% for the week ended July 26, 2008, in line with market expectations.

Inflation expectations have been trending higher owing to the sharp rise in oil prices globally (Nymex crude futures touched $145 a barrel last month). The government has
taken on a large part of the oil price rise on its books.

The fall in oil prices has reduced concerns over inflation and mounting subsidies. The pressure on the rupee also comes off as the demand for dollars from oil importers falls, which is positive for lowering inflation expectations. The rupee had touched lows of 43.50 against the dollar on the back of high oil prices. It has since recovered by 1.50 to current levels of Rs 42.

The government bond auction last week saw the cut-off on the benchmark ten year bond (the 8.24% 2018 security) come in better than market expectations. The cut-off was at 9.14% against market expectations of 9.19%. The bond rallied to close at 9.02% levels and the momentum is likely to continue into this week. The market had used the auction to cover shorts and will now look to go incrementally long, given lower oil prices.

Liquidity as measured by bids for reverse repo/repo in the liquidity adjustment facility (LAF) was tight last week. Bids for repo at 9% touched Rs 32,000 crore. Fresh product covering by banks led to liquidity tightening. Overnight rates moved up to repo levels of 9%. Liquidity is expected to remain tight owing to the auction outflows, though pressure on liquidity is likely to ease as demand eases in the reporting week.

Government bonds
Government bonds saw yields move down week on week on the back of falling oil prices. The benchmark ten year bond yield closed the week lower by 27 bps at 9.02% levels. Five-year benchmark bond yields were lower by 22 bps, with the yield on the 7.27% 2013 paper closing at 9.14% levels. Yields on the long bond, the 8.33% 2036, closed higher by 1 bps at 9.80% levels. The 10-over-30 segment of the yield curve steepened by 27 bps to close at 78 bps. The 5-over-10 segment of the curve inverted by 4 bps to close at 12 bps levels.

The government held bond auctions for Rs 10,000 crore last week. The bonds auctioned were the 8.24% 2018 for Rs 6,000 crore and the 7.95% 2032 for Rs 4,000 crore. The cut-off on the 8.24% 2018 bond came in at 9.14% against market expectations of 9.19% while the cut off on the 7.95% 2032 bond came in at 9.88% against market expectations of 9.82%.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bills) yields were lower last week on the back of improved interest rate sentiment. The cut-off on the 91-day T-bill auction held on August 6 came in at 9.23% against a cut-off of 9.36% at the previous auction. The 182-day T-bill auction saw the cut off coming in at 9.30% against 9.32% in the previous auction.

The RBI is this week auctioning Rs 3,000 crore of 91-day T-bills, all of which is under regular auction. It will also auction Rs 2,500 crore of 364-day T-bills, of which Rs 1,000 crore is under regular auction and Rs 1,500 crore is under the market stabilisation scheme.

Corporate bonds saw yields staying stable while spreads rose. The benchmark five-year AAA bond yield held steady at 10.90% levels. Credit spreads as measured by spread between five-year benchmark AAA paper and the five-year government bond moved higher by 23 bps to close at 155 bps levels. The rise in spreads was due to the sharp rally in government bond yields, while corporate bond yields held on at higher levels. Corporate bonds could see some value buying at higher levels though spreads are unlikely to come off sharply, given liquidity issues.

Overnight index swaps (OIS) saw the curve come off sharply on the back of the rally in government bond yields. The one-year OIS yield moved down by 36 bps to close last week at 9.23% levels while five-year OIS yields closed lower by 43 bps at 8.91% levels. The one-over-five OIS spread further inverted by 5 bps to close at 32 bps levels. OIS yields are likely to follow government bond yields in the coming week.

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