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The Reserve Bank of India (RBI) will focus on liquidity management in the coming weeks, given the volatility in the rupee. The rupee touched all-time lows of Rs 50 to the US dollar on the back of global risk aversion.
The outlook for the local currency is extremely negative, given the weakness in emerging markets globally. Emerging markets equities have fallen off the cliff while credit spreads have shot through the roof.
The Sensex fell over 10% on Friday as foreign institutional investors (FIIs) sold equities. Credit spreads of emerging market bonds have gone up by 300-1500 bps across rating categories. Credit markets are factoring defaults in weaker countries such as Pakistan and Argentina.
The fear of defaults has frozen lending to Indian corporate borrowers in the US dollar market. Against this backdrop, the RBI is facing an issue of negative capital flows, leading to pressure on the rupee.
The RBI is selling dollars to stem rupee volatility but, given the pressure on the rupee, the size of intervention is increasing. The RBI is reported to have sold over $5 billion last week to prevent the rupee from falling sharply. The capital outflows coupled with RBI’s dollar sales is putting pressure on liquidity.
The RBI, in the credit policy review on October 24, maintained status quo on policy rates. It had cut the cash reserve ratio (CRR) by 250 basis points (bps) and the repo rate by 100 bps in the week leading to the policy. The RBI is giving time for the measures to take effect and has chosen to keep policy rates on hold. However, it has indicated that it will use conventional and unconventional methods for liquidity management. The top priority for the RBI at this juncture is financial market stability, given the turmoil in global financial markets.
Bond markets are going into a phase of uncertainty. On the one hand global recession fears have driven down commodity prices, with oil prices coming off to two-year lows at $63 per barrel. Inflation is beginning to trend down on the back of fall in commodity prices.
Inflation as measured by the wholesale price index came in at 11.07% for the week ended October 11, 2008, as against market expectations of 11.35%. Inflation had touched highs of 12.78% in August 2008.
Growth forecasts have been revised downwards by 100 bps on the back of global economic weakness. On the other hand, dollar flows out of the country, weakening rupee, liquidity pressures and government finances are a concern. The government has indicated that it will borrow more than the budgeted Rs 39,000 crore for the second half of fiscal 2008-09. The market will have to figure out if the yield of 7.79% on the ten-year benchmark bond has fully factored in the positives.
Liquidity eased last week after the CRR cut. The CRR cut of 2.5% released Rs 100,000 crore into the system, leading to the market lending funds to the RBI at 6%. Overnight rates came off to 6% levels from 10% levels. Liquidity is expected to be tight this week given festive demand for currency, fresh product covering by banks and outflows on account of dollar sales by the RBI. Overnight rates are expected to go up to repo levels of 8%.
Government bonds
Government bonds saw yields move up week on week. The benchmark ten-year bond yield closed the week higher by 7 bps, with the 8.24% 2018 bond closing the week at 7.79% levels. The ten-year bond yield had gone down to 7.55% levels after the repo rate cut by the RBI, but gave up all its gains on the policy day as RBI chose to hold rates.
The market also fretted on the extent of government borrowing in the coming weeks leading to profit taking. Bond yields are likely to be choppy given the absolute level of yields and the uncertainty surrounding the financial markets.
The government has announced bond auctions for Rs 10,000 crore. The bonds to be auctioned on October 31 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 government cancelled the auction scheduled for October 20 as the bids went in before the repo rate cut by the RBI.
Treasury bills, corporate bonds and overnight index swaps (OIS)
Treasury bills (T-bills) yields were lower in the auction last week, with the cut-off at the 91-day T-bill auction held on the October 22 coming in at 7.19% against a cut-off of 8.69% in the previous week.
The 364-day T-bill auction saw the cut-off at 7.40% against a cut-off of 8.45% 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 182-day T-bill under regular auction.
Corporate bonds saw yields close the week on a bearish note on liquidity fears. Ten-year benchmark bond yields came off by 20 bps after the repo rate cut but closed the week 15 bps higher from lows at 11.40% levels. Yields at the short end of the curve closed 100 bps up from lows, with three-month benchmark certificate of deposit (CD) yields moving up from 11.5% levels to 12.5% levels. Corporate bonds yields are likely to be pressured on liquidity and supply worries.
OIS saw the curve steepen on the back of interest rate uncertainties. The five-year OIS yield closed up 6 bps at 6.96% levels and one-year OIS yield closed down 22 bps at 6.58% levels. The one-over-five spread steepened by 26 bps to close at 32 bps levels. The curve is likely to flatten on liquidity worries.
The author is senior fund manager — fixed income, IDFC Mutual Fund.
Views are personal.