Comment

Extreme pessimism ruled bond market sentiments last week on the back of an out-of-policy repo rate hike by the Reserve Bank of India (RBI) and a higher-than-expected domestic inflation number. Markets tanked, with ten-year benchmark bond yields moving up by 14 basis points (bps) week on week.

Interest rate swaps saw yields rise sharply, with five-year swap yields moving up by 43 bps week on week.

The RBI last week raised the repo rate (the rate at which it provides liquidity to the system) by 25 bps to 8%.

The move, after a gap of 15 months, took the market by surprise, as the RBI had refrained from raising benchmark rates in its policy meet in April 2008. RBI stated urgency to control heightened inflation expectations as the basis for the hike.

Inflation as measured by the wholesale price index (WPI) came in at 8.75% for the week ended May 31, 2008 against market expectations of 8.28%. The market is now expecting inflation to cross double digit levels in the next couple of weeks as the effect of the fuel price hike of May 2008 comes into play.

Bond yields, which were pressured by high crude oil prices (Nymex crude is hovering uncomfortable at $135bbl levels) and were discounting rate hikes by the RBI, reacted negatively to the rate hike. Yields moved higher by 10-15 bps post hike, suggesting that the market was not ready for rate hikes out of policy. The inflation number coming in higher than expectations pushed up yields further. The current levels of 8.39% on the ten-year bond and 8.63% of the five-year swap are discounting further hikes by the RBI in the near future.

Globally, rates firmed up on hawkish inflationary tones by central banks. The US Federal Reserve (Fed) acknowledged inflationary pressures and stressed on the need to control inflation expectations.

US treasury yields at the short end jumped by over 70 bps week on week as markets started factoring in rate hikes. The European Central Bank (ECB) also signaled impending hikes in July on heightened inflation expectations.

Liquidity as measured by bids for reverse reporepo in the liquidity adjustment facility (LAF) of the RBI tightened last week, with bids forrepo touching Rs 22,000 crore. Overnight rates moved up to over 8% levels on tight liquidity and the hike in the repo rate. Liquidity is expected to remain tight with auction outflows and advance tax outflows weighing on the system.

Government bonds
Government bond yields rose sharply week on week. The ten-year bond yield closed higher by 14 bps, with the benchmark ten-year 8.24% 2018 paper closing the week at 8.39% levels. Five-year benchmark bond yields were higher by 13 bps with the yield on the 7.27% 2013 bond closing at 8.39% levels.

Yields on the long bond, the 8.33% 2036 bond, closed higher by 13 bps at 8.80% levels. The ten-over-thirty spread closed flat at 41 bps levels while the five-over-ten spread flattened out completely.

The government has announced a dated bond auction for Rs 6,000 crore on June 20.
The auction is as per the schedule given in the government borrowing calendar for the first half of fiscal 2008-09. The bond to be auctioned is the 8.24% 2028 paper. The bond is an off-the-run bond and will find demand only from investors such as insurance companies and provident funds. The cut-off is immaterial for the market.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were higher last week. The cut-off on the 91-day T-bill auction held on June 11 came in at 7.69% against a cut off of 7.56% seen in the previous auction. The 182-day T-bill auction saw the cut-off at 7.68% against a cut-off of 7.53% seen in the previous auction.

The RBI is auctioning Rs 2,000 crore of 91-day T-bills under regular auction and Rs 1,000 crore of 364-day T-bills under regular auction this week.

Corporate bonds saw yields move higher on interest rate and liquidity worries. Five-year yields were trading in the 9.85% to 9.90% range, up by 15 bps week on week. Yields at the short end rose sharply by 25 to 30 bps as liquidity and supply worries hit the market.

Credit spreads were flat week on week, with benchmark five-year AAA spreads closing at 132 bps levels. Corporate bond yields will become sticky at higher levels, with interest from banks, insurance companies and provident funds absorbing trader supplies.

Overnight index swaps (OIS) saw the curve move up sharply on extreme pessimism. One-year OIS yields moved up by 50 bps to close last week at 7.40% levels while five-year OIS yields closed higher by 43 bps at 8.63% levels. The one-over-five spread flattened by 7 bps week on week to close at 23 bps levels.

The curve will see high volatility given levels are at multi-year highs and traders are uncertain on direction from these levels.

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