Comment

Falling inflation, indications of economic slowdown among the reasons

The 10-year benchmark government bond yield fell to its lowest in three years on the back of strong rate-cut expectations.

The market is expecting the Reserve Bank of India (RBI) to cut policy rates before its policy review meet in January 2008. The rate-cut talk is fuelled by a sharp fall in inflation, expectations of growth slowing down substantially, and the policy shift of the RBI from inflation to growth.

Rate cuts by central banks across geographies — from China to the US — are boosting similar expectations in India. China cut rates by 1% last week to spur a flagging economy.

The markets are also enthused by expectations of a cut in fuel prices by the government, which will help take inflation below 5% levels, given the current trend in the wholesale price index (WPI).

The conditions for growth are deteriorating with all economic indicators showing signs of a slowdown. The index of industrial production (IIP) grew at 4.9% for the April-September 2008 period as against 9.5% for the April-September 2007 period. GDP growth for the second quarter of 2008-09 is at 7.6% as against 9.3% for the second quarter of 2007-08.

The slowdown in domestic growth is against the backdrop of a severe fall in global economic growth. Advanced economies are expected to go into recession in the next few quarters while China, the world’s fastest growing economy, is forecast to grow at 7.5% against the double-digit growth seen last year.

The global slowdown in growth is good for inflation and inflation expectations. Domestic inflation numbers have gone below 9% in November 2008 after seeing highs of over 12.5% in August 2008. Inflation, as measured by the WPI, came in at 8.84% for the week ended November 15, 2008. The sharp fall in inflation has been due to the slide in commodity prices. Oil prices have come off by over 60% from highs, while indices tracking a basket of commodities have come off by over 40% from highs.

The market is still apprehensive of the excess government borrowing that is expected any time soon. However, given that the government will borrow to pump-prime the economy, lower cost of borrowing for the government is essential. The RBI is expected to reduce policy rates before the government embarks on fresh borrowing.

Liquidity was neutral last week, with bids for reverse repo at 6% and repo at 7.5% cancelling out each other. Overnight rates hovered in the 6-7.5% band.

Liquidity is expected to be neutral-to-negative this week given no major outflows/inflows are expected in the system. Overnight rates are likely to stay in the 6-7.5% band.

Government bonds
Government bonds saw yields move down week-onweek. The benchmark ten-year bond yield closed the week lower by 11 basis points (bps), with the 8.24% 2018 paper closing at 7.08% levels. The yield on the five-year benchmark bond, the 7.56% 2014, closed down 13 bps week-on-week at 7.02% levels. The yield on the long bond, the 7.95% 2032, moved down by 2 bps week-on-week to close at 7.69% levels. The 10-over-24 spread moved up 8 bps to 61 bps levels. The spread is likely to contract on the back of rate-cut expectations.

Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bill (T-bill) yields were lower at the auction last week, with the cut-off at the 91-day bill auction on November 26 coming in at 7.14% against a cut-off of 7.31% in the previous week. The 182-day T-bill auction saw the cut-off at 7.06% against a cut-off of 7.38% at the previous auction. The RBI is this week auctioning Rs 3,000 crore of 91-day T-bills and Rs 1,000 crore of 364-day T-bills under regular auction.
Corporate bonds saw yields ruling steady at higher levels. Ten-year benchmark AAA spreads rose 30 bps to 386 bps levels while five-year benchmark AAA spreads moved up by 10 bps to 428 bps. Primary issues are expected to hit the market in a flurry given that higher spreads may attract investors, enabling issuers to clear large sizes of issuances. Credit spreads are likely to be pressured on the back of supply expectations.

OIS saw the yields move up on profit-taking at lower levels. The five-year OIS yield closed up 20 bps at 5.70% levels and the one-year OIS yield closed up 10 bps at 5.40% levels. OIS yields are likely to stay bullish given rate cut expectations.

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