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Yield curve flattening signals rate hike

Case for a hike getting stronger as all the key factors are trending higher than expected.

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Case for a hike getting stronger as all the key factors are trending higher than expected.

Government bonds saw the long ends rally sharply last week, flattening the yield curve by 9 basis points (bps) in the 5 over 30 segment of the curve. The curve has flattened by 21bps over the last two weeks in this segment. The long ends rallied on hopes that an expected rate hike in the October monetary policy would help the Reserve Bank of India (RBI) contain inflation at around 5% levels.

The benchmark long bond, the 7.50% 2034, rallied by 11bps to close the week at 8.13%. The five-year bond, the 9.39% 2011, saw yields down by 2bps to close at 7.39% levels. The 5 over 30 spread came off by 9bps to close last week at 75bps from 84bps seen in the week before.

The case for rate hikes is becoming stronger given that all factors the RBI considers in its interest rate policy are trending higher than forecast levels. Inflation is expected to cross 5% as the base effects start wearing off and prices of primary articles continue to rise.

The latest weekly report released by the RBI shows that broad money growth (19.5%), non-food credit growth (31%) and deposit growth (21.3%) are all trending higher than RBI expectations of 15%, 20% and 15% respectively for the week ended September 15, 2006.

The overnight rise in yields of 10bps in US treasuries on an upward revision in August non-farm payrolls numbers signals that the US would continue to maintain a tight money policy longer than expected.

This week should see the markets open weak on overnight falls in US treasuries. The markets would also await a government bond auction announcement, which is scheduled for the October 6-13 period. Yields are expected to rise by 10bps as nervousness increases on rate hike expectations.

Liquidity
Liquidity, as measured by the bids for repo/reverse repo in the liquidity adjustment facility (LAF) auction conducted by RBI, was higher last week with the daily average LAF bids accepted by RBI last week for reverse repo at 6% at Rs 21,366 crore against Rs14,698 crore in the week before. There were no bids for repo at 7% last week.

The last day of the week saw the RBI sucking out Rs 29,070 crore from the system by accepting reverse repo bids in the LAF. Overnight rates came off on easier liquidity conditions with call rates closing the week at 6.40% levels from 7.5% levels in the week before last and repo closing at 6.25% levels from 7.5% earlier.

Liquidity eased on government spending and lower demand from banks in the beginning of the second half of fiscal 2006-07. Demand for funds may increase towards the second half of the month as the festive season approaches. Credit offtake is also expected to increase as the busy season gets underway. Overnight rates are likely to remain pressured on expected fall in system liquidity.

Government securities
Government bonds saw the long ends rally, while gains were muted in the medium term bonds. The yield on the benchmark 10-year bond, the 7.59% 2016, fell 4bps week-on-week to close last week at 7.60% levels against 7.64% in the week before last. The long bond, the 7.50% 2034, saw yields move down by 11bps week-on-week to close last week at 8.13% levels.

The benchmark five-year bond, the 9.39% 2011, saw yields fall by 2bps to close last week at 7.39% levels from 7.41%. The benchmark 15-year bond, 7.94% 2021 bond saw yields fall by 10bps over the week to close last week at 7.82% levels. The 8.07% 2017 bond saw yields fall by 4bps week-on-week, while the 8.33% 2036 bond saw yields fall by 9bps week-on-week. The curve flattened in the five over thirty segment as long bond yields fell. The 5 over 30 spread came off by 9bps to close last week at 75bps levels.

Volumes were lower in the bond market last week with daily volumes in the government bond market averaging Rs 3,858 crore against Rs 5,289 crore in the previous week. Inflation, as measured by the changes in the Wholesale Price Index, came in above market expectations for the week ended September 23, 2006. Inflation came in at 4.77% against expectations of 4.66%.

This week will see a government bond auction of Rs 9,000 crore. The bonds to be auctioned are 10-14 year maturity bonds for Rs 6,000 crore and 20-year and above maturity bonds for Rs 3,000 crore. The markets would expect the government to reissue on-the-run benchmark bonds in the auction. The cut-off would be keenly awaited to gauge the markets expectations on interest rates in the October policy meet of the RBI.

Treasury bills
The 91-day Treasury bill (T-bill) auction on October 3, 2006 saw a cut-off of 6.60% against a similar cut-off in the previous auction. The 182-day T-bill auction saw a cut-off of 6.80% last week against a cut-off of 6.78% in the previous auction. T-bills yields are expected to trend higher on rate hike worries.

Corporate bonds
Corporate bond markets saw Tata Sons being active in the private placement market, placing three-year bonds at 8.60% levels. Tata Sons and Tisco credit spreads could widen if Tisco goes in for a leveraged acquisition of Corus. The corporate bond market could see more activity as corporates access the market to fund their growing capital expenditures. Spreads are expected to widen as supply pressure increases.

Overnight index swaps (OIS)
The OIS market saw the five-year OIS yields fall by 2ps week-on-week to close last week at 7.04% levels, while one-year OIS yields rose by 1bps to close at 6.68% levels. The one over five OIS spread was down by 3bps week-on-week to close last week at 36bps. OIS yields are expected to rise in the coming week as the market factor in expectations of rate hikes in the October monetary policy.

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