RBI has pulled the plug on yields

The Reserve Bank of India (RBI) has inadvertently pulled the plug on bond yields.

A higher-than-expected cash reserve ratio (CRR) hike in the policy review and the post-policy statements made by governor D Subbarao will push up 10-year yields sharply from current levels of 7.60%.

Bond yields have held a tight range of 7.45% to 7.65% over the last couple of months as the market hoped that threats from inflation, policy rate hikes and bond supply will not materialise.

All three have reared their ugly heads and participants will now gauge their potential impact on interest rates.

The threat from inflation is real. RBI has sharply raised end-March 2010 forecast for wholesale price index (WPI) growth to 8.5%.
The 200 basis points (bps) rise in inflation forecast from earlier expected levels of 6.5% was not followed by a hike in reverse repo/ repo rates.

Mint Road chose to raise CRR by 75 bps to suck out liquidity to contain higher trending inflation expectations.

Post-policy comments by Subbarao indicate reverse repo/ repo rate hikes will follow the CRR hike.

The bond market will now be nervous on rate hikes happening before the annual policy for the next fiscal scheduled in April, especially since a few participants are expecting inflation to touch double digits in March.

The nervousness of pre-policy rate hikes will be compounded by bond supply fears. Subbarao mentioned that the RBI is expecting bond supply for fiscal 2010-11 to match or even exceed the current fiscal’s levels of Rs 450,000 crore.

He expressed fears of managing the borrowing programme given the fact that higher inflation expectations and lack of market stabilisation scheme bonds may hamper RBI’s efforts to smoothen out the borrowing programme.

The market will take yields up to brace for a front-loading of the borrowings programme next fiscal.

The Union Budget for 2010-11 to be presented on February 26 will indicate the exact extent of government borrowings.

There are doubts on the current year’s borrowings too, with government finances looking weak. April-December 2009 fiscal deficit reaching 77.3% of full year’s target, while tax revenues have dipped 2.5% on year against budget estimates of a 15% growth.

The government will face additional pressure of Rs 35,000 crore on its finances due to the uncertainty on 3G spectrum auctions and a higher-than-budgeted fertiliser subsidy bill of Rs 20,000 crore.

The government is vehemently denying that it will borrow more than scheduled this fiscal, but till the deficits are met the market will be on tenterhooks fearing more supply.

Friday’s CRR hike will suck out Rs 36,000 crore from the system.
The current systemic liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction, is around  Rs 70,000 crore.

Liquidity can get further crimped through traditional fiscal year end demand for funds, equity disinvestments which are subscribed to largely by domestic investors and the proceeds go to fund deficits and advance tax outflows. Overnight rates are expected to trend higher as the market hoards up on liquidity on expectations of a tightening down the line.

Government bonds
Government bonds saw yields rise across the curve on the back of a higher-than-expected CRR hike. Yields on the 6.35% 2020 closed 2bps higher week on week at 7.59% levels, while the 6.90% 2019 closed at 7.79%, also up 2bps. The five-year benchmark, the 7.32% 2014, saw yields rise 3bps at 7.16% levels, while yields on the 8.24% 2027 rose by 5bps at 8.27%.

The government is auctioning Rs 8,000 crore of bonds this week including the 7.02% 2016 for Rs 3,000 crore, the 6.35% 2020 for Rs 3,000 crore and the 8.24% 2027 for Rs 2,000 crore.

Treasury bills, corporate bonds, OIS
Yields were higher at the 91-day treasury bill auction held on January 27 with the cut-off coming in at 4.01% against 3.93% seen in the previous auction. The 364-day bill auction saw the cut off at 4.70% against 4.67% earlier. The RBI is auctioning Rs 7,000 crores of 91-day and Rs 1,500 crores of 182-day bills this week.

Corporate bonds saw yields rise week on week. Five- and ten-year bonds traded higher by 3bps at 8.35% and 8.70%, respectively.
Credit spreads were flat at 107bps and 82bps for the five- and ten-year segments, respectively.

Corporate bond yields are likely to  move higher on worries of liquidity and rising government bond yields. Primary supply will also increase as issuers line up borrowings before interest rates harden.

Overnight index swaps (OIS) saw the curve flatten week on week. The five-year OIS yield closed lower by 3bps at 6.88% levels, while the one-year OIS yield ended up 10bps at 5.03% levels.

The one-over-five spread closed down 13bps  at 185bps levels. The OIS curve is likely to move higher on tightening liquidity and hardening interest rate worries.
 
The author is head-fixed income, IDFC Mutual Fund. Views are personal.