What are the yield curves trying to tell us?

The Reserve Bank of India (RBI) is likely to maintain status quo on rates in its June review as there are signs of inflation-driving factors cooling off

The RBI efforts in containing inflation will bear fruit down the line, that is what the yield curves across interest rates and credits show. If this is not the case, then the curves are completely wrong in the assessment of interest rate conditions down the line. If the former is true, the curves should start steepening once the RBI signals end of the rate tightening cycle. On the other hand, if the latter is true yields at the mid to long segment of the curve can go up sharply. I believe that the curve is right in its assessment of inflation coming off and that the RBI will signal an end to the rate tightening sooner than later.

On the government bond side, the yield curve is inverted at the short and mid segments while it is flat at the long end. On the credit side, the yield curve is inverted at the short and mid segments while the swap curve has almost flattened out. One year treasury bill yields are trading at 8.30% levels while 10-year government bond yields are trading at 8.35% levels. The last bond auction saw the five year bond cut off coming in at 8.49% and the 11-year bond at 8.49%. The 15-year bond cut off came in at 8.64% while the 30-year bond is trading at 8.67%. Inversion at the five over ten segment of the curve coinciding with flatness at the ten over fifteen and thirty segment of the curve is a sign that the markets are expecting yields to fall from current levels once inflation shows signs of coming off. However, this may not immediately happen and this scenario can continue for a while till the market gets comfort on the inflation front. The OIS curve (overnight index swap) has also seen flattening with the five over one OIS spread coming off to 10 bps from levels of close to 50 bps seen a month ago. The flattening of the swap curve is corroborating the inversion in the government bond curve. The market expects the RBI to hike rates further and liquidity is expected to remain tight while inflation is likely to trend down in the coming months as rate hikes take effect.

The credit curve too is showing inversion with one year benchmark paper yields trading at 9.95% levels, five year benchmark AAA yields trading at 9.60% levels and ten year benchmark AAA yields trading at 9.50% levels. The corporate bond curve is exhibiting a view similar to that of the government bond and swap curves.

All the curves will start steepening with the short end yields coming off sharply, once the RBI signals an end to rate hikes. The question is when will this come about? The RBI has sounded extremely hawkish in post-policy statements helping the market in its views of more rate hikes ahead. However, the hawkishness could also mean that policy rates will be kept at higher levels after the last 50 bps hike took up repo rates to 7.25% and not raised further. I am expecting the RBI to maintain status quo on rates in its June review as there are signs of inflation-driving factors cooling off. Food inflation has come off to below 7.50% levels from high double digit levels while credit growth has come off from 24% levels to 21.5% levels. Oil prices once passed through will impact inflation but that has been factored in RBI’s inflation forecasts. Global factors are also seen helping inflation with growth projections in China trending down on the back of rate hikes and other inflation control policy measures. The end of quantitative easing by the US Fed in June is also a positive sign of inflation coming off.  Hence, the RBI is likely to give more weight to these factors especially since it has hiked rates by a more than expected 50 bps in the May policy meet.

The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.59% 2016 bond for Rs4000 crore, the 8.08% 2022 bond for Rs5000 crore and the 8.26% 2027 bond for Rs3000 crore. The cut offs came in at 8.49%, 8.49% and 8.64% respectively. The RBI devolved Rs631 crore of 7.59% 2016 bond on to the underwriters. The government is scheduled to auction Rs12,000 crore of bonds this week.