Comment

The bond market is likely to see choppy trading with oil price movements, domestic inflation numbers and auction cut-off expectations driving the trend.

The major event — the first quarter review of the monetary policy by Reserve Bank of India (RBI) — having passed, the market will now have to take near-term cues for direction.

RBI hiked the repo rate by 50 basis points (bps) and the cash reserve ratio (CRR) by 25 bps in its policy review. The market had expected a 25 bps repo rate hike and was undecided on the CRR hike. The higher-than-expected rate hikes took up bond yields with the ten-year benchmark yield rising by 40 bps post policy.

The market rallied the ten-year bond from highs of 9.45% post-policy to levels of 9.28% at the close of trading last week. The rally was on hopes of oil prices coming off and domestic inflation stabilising.

Oil prices had touched lows of $121/bbl before moving up to levels of $127/bbl and closed last week at around $125/bbl. Inflation as measured by the Wholesale Price Index came in at 11.98% for the week ended July 19, 2008, as against the market expectation of 12.03%. The market is hoping inflation will stay around 12% levels and expectations of levels of 14% have come off.

The market was also enthused by the finance minister’s statement that interest rates could come off in the longer term. The market took the short-term cues to cover the shorts which had been built post-policy.

This week will see the market positioning itself for the auction. The government has announced a uniform-price auction of Rs 10,000 crore, scheduled for August 8. The auction is as per the borrowing calendar for the first half of fiscal 2008-09. The bonds to be auctioned are the 8.24% 2018 bond for Rs 6,000 crore and the 7.95% 2032 bond for Rs 4,000 crore.

The government had, in the last auction, deviated from the traditional multiple-price auction it had been following. It perhaps feels it can get better price in uniform-price auctions, though the market prefers multiple-price auction as price discovery is better and there is scope for rallies after the cut-off. The market will go short into the auction given that there are no positive cues in the near term for bond yields to come off.

Liquidity as measured by bids for reverse repo or repo in the liquidity adjustment facility (LAF) eased last week, with bids for repo at 9% coming off from Rs 30,000 crore to Rs 13,000 crore. Banks were well-covered in their products leading into the reporting week and this led to liquidity easing. The RBI has started the practice of two LAFs on reporting Fridays to ease liquidity management.

Overnight rates came off sharply from highs of 9.5% to below 6% levels on easing liquidity. Liquidity is expected to remain tight given fresh product covering by banks. Overnight rates are likely to trade at the 9-9.50% levels.

Government bonds
Government bonds saw yields move up week-on-week on the back of RBI hiking policy rates. The benchmark ten-year bond yield closed the week higher by 13 bps — the 8.24% 2018 bond closed at 9.29% levels. Five-year benchmark bond yields were higher by 9 bps with the yield on the 7.27% 2013 bond closing at 9.36% levels. Yields on the long bond, the 8.33% 2036 bond, closed higher by 11 bps at 9.79% levels. Bond yields will take cues from auction cut-offs this week.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were higher last week on the back of rate hikes by the RBI. The cut-off on the 91-day T-bill auction held on July 30 came in at 9.36% against a cut-off of 9.05% seen in the previous auction. The 364-day T-bill auction saw the cut-off coming in at 9.56%, against a cut-off of 9.45% seen in the previous auction. The RBI, this week, is auctioning Rs 3,000 crore of 91-day T-bills, all under regular auction and Rs 1,500 crore of 182-day T-bills of which Rs 500 crore is under regular auction and Rs 1,000 crore is under the Market Stabilisation Scheme.

Corporate bonds saw yields rise on the back of RBI policy rate hikes. The benchmark five-year AAA yields moved higher by 20 bps from 10.70% levels to 10.90% levels. Credit spreads, as measured by the spread between the five-year benchmark AAA paper and the five-year government bond, moved higher by 10 bps to close at 132 bps levels. The corporate yield curve was inverted with one-year papers dealt at 11% levels. Corporate bonds will see yields holding firm at higher levels on the back of higher supply.

Overnight index swaps (OIS) saw the yield curve invert on the back of RBI policy measures. The one-year OIS yield moved higher by 11 bps to close last week at 9.59% levels, while five-year OIS yields closed lower by 9 bps at 9.32% levels. The five-over-one OIS spreads inverted by 20 bps to close at a negative 27 bps. OIS yield curve may flatten if liquidity eases.

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