Fall in rupee, inflation perk up bonds

MUMBAI: The news of the week has been the turmoil in the global financial markets, especially the stock and currency markets. The primary trigger for the sharp fall in global stock prices and the value of the dollar has been the effective seizure of the credit markets in America.

What started with the subprime mortgage segment of the market quickly spread to other parts of the credit market, such as asset backed commercial papers. Effectively, borrowers were finding it extremely difficult to arrange for funds, prompting the US Fed to intervene on Friday. The Fed cut the rate on its discount window by 50 basis points from 6.25% to 5.75%.

More importantly, borrowers were allowed to borrow up to 30 days from this window instead of the usual one day. The discount window is used by the Fed to inject funds into the system against a variety of collateral securities including home mortgages. The Fed move aimed at easing conditions in the credit markets had its desired effect and stock prices recovered sharply after the move.

The spread of the subprime contagion has already started taking a toll elsewhere. Goldman Sachs had to inject close to $3 billion into its quant fund to bring down the leverage of the fund from 6:1 to a more realistic 3:1. Sentinel Management Group froze its money market substitute fund as trading in the market for commercial paper took a sharp hit.

The difficulties faced by Countrywide Financial, the largest mortgage lender in the US, to arrange for financing have been well reported. It even went to the extent of some analysts predicting bankruptcy for Countrywide.

All this led to a flight to quality, triggering a sharp fall in yields of short-term treasuries, with 3 month treasury bills trading almost 100 basis points lower than the levels witnessed in the previous week.

Some analysts opine that some marketmen had a whiff of the impending Fed move and the sharp fall in yields on treasury bills was a result of this.

Back home, bond markets had a relatively quiet shortened trading week, with the benchmark 10-year bond closing the week at a yield of 7.97%. The bond’s yield had touched a high  of 8.04% mid week but prices recovered to end the week relatively flat.

Corporate bonds : Indicative yields on benchmark 5-year AAA corporate bonds were 9.53% by the end of the week, marginally higher by about 5-6 basis points relative to its weekly opening levels.

Overnight index swaps :  5-year OIS levels closed the week at 7.61% levels up by approximately 5 basis points over the weekly opening levels. 1-year OIS levels were higher by about 10 basis points from their opening levels. One-year swaps closed the week at approximately 7.50% levels.

Inflation : Headline inflation came in at 4.05% for the week ended August 3, significantly below the 4.30-4.35% levels expected by the market. This number being close to the comfort level of the central bank on inflation should provide succour to bond markets and help in supporting prices.

Forex reserves : Forex reserves for the week ended August 10 dropped by $346 million to $229 billion.

MSS : The RBI has only announced issuance of treasury bills under MSS this week. This should also help improve market sentiment.

Fresh supply : The government proposes to auction two government bonds on August 24 - Rs 5000 crore worth of 7.27% bonds maturing 2013 and Rs 2000 crore worth of 7.99% bonds maturing 2017 as part of its regular borrowing program.

Outlook: The lack of significant MSS supply, generally improved global sentiment, lower inflation readings, fall in the value of the rupee vis a vis the US dollar, all point to improved sentiment for bond markets. Prices are, therefore, expected to be well supported. However, political tensions over the India-US nuclear deal could play spoilsport.

Singh is founder of Finanzlab Advisors, an independent financial markets and risk management consultancy. dheeraj.ds@gmail.com