Comment

Fear of govt finances weakening will prevent bond yields from rallying

The first of the market stabilisation scheme (MSS) bond buyback to boost liquidity set the direction for bond yields.

The Reserve Bank of India bought back Rs 10,000 crore of one-year dated bonds issued under MSS last week. The bonds bought back were the 5.48% 2009 and the 6.65% 2009 bonds for Rs 5,000 crore each. The RBI bought the bonds at yields of 6.80% and 6.86% respectively. The yields were almost 35 basis points (bps) lower than the cut-off on the 364-day T-Bill auction held on the day prior to the bond buyback.

The acceptance of the bonds at below market yields by the RBI indicates that the central bank is comfortable with the lower levels of yields at the short end of the curve.
The MSS bond buyback was accompanied by a government bond auction for Rs 10,000 crore. The bonds auctioned were the 8.24% 2018 bond for Rs 6,000 crore and the 8.28% 2032 bond for Rs 4,000 crore. The auction cut-offs came in at 7.72% and 8.44% respectively with the 8.28% 2032 bond devolving on primary dealers for Rs 1,228 crore. The cut-off yields were way higher than the lows of 7.45% seen in the 8.24% 2018 bond and 7.96% seen in the 2032 bond.

The spike in long bond yields after the 50 bps repo rate cut and the 100 bps CRR (cash reserve ratio) cut reflects the RBI actions in buying back bonds at the short end of the curve and supplying bonds at the long end of the curve. The yield curve steepening was reflected in the spread between the newly issued 7.56% 2014 bond and the benchmark ten year 8.24% 2018 bond.

The spread widened from negative 7 bps to positive 23 bps over the week. However, given that the next auction scheduled is likely to be a reissue of the 7.56% 2014 bond, the spreads may contract into the auction.

The market will also factor in the volatility in currency markets and system liquidity in determining bond yields. The sharp policy response to the ongoing turmoil in financial markets across the globe has brought down bond yields by 200 bps from highs. If financial markets and currencies stabilise and liquidity eases, further monetary easing may not be necessary.

The markets are also bracing for a strong fiscal stimulus globally, which will see governments increasing fiscal deficit to spend. The fear of government finances weakening will keep bond yields from rallying despite sharp falls in inflation and growth.
Domestic inflation was higher than expected last week with inflation as measured by the WPI (Wholesale Price Index) coming in at 10.72% for the week ended October 25, 2008 against market expectations of 10.45%. Inflation does not seem to be a threat given sharp falls in commodity prices and signs of global recession. US lost 2,40,000 jobs in October 2008 and unemployment rate went up to 6.5% indicating that the world’s largest economy is spiralling into a recession..

Liquidity eased last week after the CRR cut. The CRR cut of 50bps released Rs 20,000 crore into the system leading to the market lending funds to the RBI at 6%.
Liquidity is likely to be easy this week on the back of the CRR cut. Overnight rates are likely to hover around reverse repo levels of 6%.

Government bonds
Government bonds saw yields move up week-on-week.The benchmark ten-year bond yield closed the week higher by 20bps with the 8.24% 2018 bond closing the week at 7.69% levels. The 7.95% 2032 bond yield moved up by 33bps week on week to close at 7.36% levels. The yield curve steepened with the newly issued 7.56% 2014 bond yield moving down 13bps week on week.

Government bond yields are likely to be ranged given the uncertainty surrounding financial markets.

Treasury bills, corporate bonds and overnight index swaps
Treasury bills (T-bills) yields were lower in the auction last week with the cut-off on the 91-day T-bill auction held on November 5, 2008 coming in at 7.39% against a cut-off of 7.44% seen in the previous week.The 364-day T-bill auction saw the cut-off coming in at 7.37% against a cut-off of 7.40% seen 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 move down as liquidity eased. Ten-year benchmark bond yields came off 20bps to trade at 11.30% levels.

Yields at the short end of the curve came off sharply with one-year certificate of deposits trading at 10.50% to 11% levels from 12% to 12.50% levels. The market will gauge incremental supply and liquidity outlook before taking a call on direction on yields from current levels.

Overnight index swaps (OIS) saw the curve steepen on the back of easing liquidity. The five-year OIS yield closed up 5 bps at 6.60% levels and one-year OIS yield closed down 40bps at 6.10% levels. The one-over-five spread steepened 45bps to close at 50bps levels. OIS yields are likely to remain ranged at current levels.

Disclaimer: The author is senior fund manager - Fixed Income IDFC Mutual Fund. Views are personal