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Interest rates the biggest beneficiary of the market turmoil

The current financial market turmoil has benefited interest rates, with the ten-year benchmark government bond yield falling 48 bps week-on-week. The trend for bond yields is down, though there could be hiccups in the form of currency weakness and tight liquidity.

The fear of recession globally has driven down the bugbear of inflation and rising commodity prices. Oil prices have come off sharply with Nymex crude futures falling below $80/bbl levels, down 45% from highs. Equity markets have fallen off the cliff with most of the global indices trading at multi-year lows. Equity markets are discounting deep recession brought about by the global credit crisis. The credit freeze has driven up credit spreads globally even as central banks have been cutting benchmark rates and pumping liquidity into the system. The fall in commodity and equity prices and rate cuts by central banks are positive for interest rates and if economies go into slow growth or recession, inflation will come off leading to further falls in interest rates.

The RBI and the central government played their part in providing liquidity to the system and calming nervous financial markets.

The RBI cut the CRR (cash reserve ratio) by 150 bps to add Rs 60,000 crore into the system. The government cancelled a Rs 10,000 crore government bond auction to reduce pressure on liquidity. The actions by the RBI and the government followed the concerted rate cuts by five central banks. The US Federal Reserve, European Central Bank, Bank of England, Bank of Canada and Sweden’s Riskbank cut benchmark rates by 50 bps while China’s central bank cut the policy rate by 27 bps and the CRR by 50 bps.

The unprecedented move by central banks indicated the seriousness of the global credit situation.

The move also indicated that providing liquidity and keeping interest rates low is the primary interest of central banks across the world in order to provide stability to the financial markets.

The IIP (index of industrial production) and inflation numbers came in positive for interest rates. The IIP number for August 2008 came in at 1.3% against market expectations of 6% while inflation as measured by the WPI (wholesale price index) came in at 11.80%, for the week ended September 27, 2008 as against market expectations of 12%.

The risk to interest rates is in the form of a sharply depreciating rupee. The rupee is down over 18% to the US dollar year-to-date and is in danger of further depreciation. Global aversion to risk has seen unwinding of carry trades and this is causing pressure on emerging market currencies.

The foreign exchange reserves have fallen to $283 billion down from levels of $315 billion. The fall in foreign exchange reserves is causing high pressure on system liquidity.
Liquidity was tight last week with liquidity as measured by bids for reverse repo/repo in the LAF (liquidity adjustment facility) auction seeing bids for repo at 9% touching Rs 90,000 crore. Overnight rates were at 15% to 20% levels on reporting Friday. Liquidity is expected to ease this week with Rs 60,000 crore coming into the system through the CRR cut. However, the system will continue to access the RBI window for funds given the inherent liquidity shortage and US dollar sales by the RBI to stem rupee volatility.

Government bonds: Government bonds saw yields move down week-on-week.The benchmark ten-year bond yield closed the week lower by 48 bps with the 8.24% 2018 bond closing the week at 7.80% levels. The 7.94% 2021 bond saw yields move down by 64 bps week-on-week to close at 8.13% levels.

The CRR cut, cancellation of government bond auction, rate cuts by global central banks, lower IIP and inflation numbers and fall in oil prices helped bring down bond yields. There are no government bond auctions scheduled for this week.

Treasury bills, corporate bonds and overnight index swaps: Treasury bills (T-bills) yields were lower last week with the cut off on the 91-day T-bill auction held on October 8, 2008 coming in at 8.48% against a cut-off of 8.86% seen in the previous week. The 364-day T-bill auction saw the cut-off coming in at 8.45% against a cut-off of 9.01% 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 moving higher even as government bond yields fell. Ten-year benchmark AAA yields were higher by 30 bps at 11.50% levels while ten-year benchmark bond spreads were higher by 88 bps at around 352 bps levels. Short end of the curve saw yields move up sharply with three month bank certificate of deposit yields moving higher by 150 bps at 14% levels.

Corporate bonds yields are likely to be pressured on liquidity and supply worries.
Overnight Index Swaps (OIS) saw yields come off on positive interest rate sentiments.
The five-year OIS yield came off by 66 bps to close at 7.24% levels and one-year OIS yield closed 148 bps lower at 7.37% levels. The one-over-five spread flattened by 82 bps to close at 13 bps levels. OIS yields may look to give back some gains given the negative carry.

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