Negative surprise likely from RBI

Investors should look to pare positions

Bond yields fell around 8 bps on a week-on-week basis on expectations that the RBI will maintain status quo on policy rates in its second-quarter review of the annual
monetary policy for 2007-08, on October 30.

The benchmark 10-year bond closed the week at 7.82% levels from 7.90% levels seen in the week before last.  

The markets are of the view that the recent move by Sebi (Securities Exchange Board of India) in curbing portfolio flows through the participatory note route may check large flows of liquidity into the system.

The RBI has been grappling with excess liquidity that threatens to stem export competitiveness through an appreciating rupee.

The excess liquidity is also adding to inflationary fears through high money supply and asset price bubbles.

The RBI has been controlling liquidity through higher CRR (cash reserve ratio) and issue of MSS (market stabilisation scheme) bonds. 

The other factors in favour of RBI being neutral on rates are the fall in headline inflation (WPI or wholesale price inflation came in at 3.07% for week ended October 13, 2007, against over 5% levels a year ago) and fall in credit growth (23.4% against over 28% a year ago).

In global markets, the US Federal Reserve is widely expected to cut benchmark rates by 25 bps this week, on the back of a severe slowdown in the housing market.

US treasuries have rallied by over 30 bps over the last couple of weeks on rate-cut expectations.

The RBI, however, may throw a negative surprise to the markets given the higher risk financial markets are carrying at present.

The sharp rise in oil with crude trading at over $92/barrel has given rise to oil shock fears and inflationary concerns.

The Fed cut expectations are fuelling fresh dollar weakness against emerging market currencies leading to sharp rise in flows into emerging market assets.

Commodity prices are also rallying on the back of dollar weakness. The threat to inflation and asset bubbles are higher given the surge in liquidity flows.

The RBI has also no cause to raise any alarm on growth given that recent economic indicators including GDP growth, industrial production and corporate profits have been pointing to steady expansion.

Even if the RBI maintains status quo on rates, it will sound hawkish enough to give warnings of quick policy measures if threat to stability increases.

Investors should look to pare positions. 

Liquidity as measured by bids for reverse repo/ repo in the LAF (liquidity adjustment facility) of the RBI was down week on week.

Bids for reverse repo at 6% at end of last week  was at Rs 18,000 crore levels against over Rs 32,000 crore seen in the week before last.

Overnight rates are expected to remain at around 6% levels given the current liquidity in the system.

Government bonds

Government bond yields closed down week on week. The yield on the benchmark 10-year bond 7.99% 2017 bond closed down by 8 bps to close at 7.90% levels.

Five-year benchmark bond yields closed down by 6 bps with the yield on the 7.40% 2012 bond closing at 7.75% levels. Yields on the 8.33% 2036 bond closed at 8.32% levels, down 10 bps week on week.

The five over thirty segment of the curve flattened 4 bps to close the week at 57 bps levels. 

The RBI held government bond auctions under the MSS last week. The MSS auction of 5.87% 2010 bonds for Rs 3,000 crore and the 11.30% 2010 bonds for Rs 3,000 crore saw the cutoffs yields come in lower than the previous auction cut offs.

The cutoffs came in at  7.66% for the 5.87% 2010 bond and at 7.76% for the 11.30% 2010 bond, lower by 14bps and 10bps respectively. 

The RBI held government bond auctions under the government borrowing programme last week. The bond auction of 7.27% 2013 bonds for Rs 4,000 crore and the 8.35% 2022 bonds for Rs 4,000 crore saw good bidding interest and the cutoffs yields came in lower than expectations.

The cutoffs came in at  7.74% for the 7.27% 2013 bond and at 8.13% for the 8.35% 2022 bond.

This week will see the RBI auctioning bonds under the MSS.. The RBI is auctioning Rs 3,000 crore each of 5.87% 2010 bond and 11.30% 2010 bond. The policy review will determine the outcome of the auctions.

T-Bills, corporate bonds and overnight index swaps

Treasury bills (T-bills) yields were lower week on week on the back of positive sentiments.

The cut off on the 91-day T-bill auction held on the October 24 came in  at 7.02% against a cut off of 7.10% seen in the week earlier to last.

The 364 day T-bill auction saw the cut off coming in at 7.36% against 7.37% seen in the previous auction.

The RBI is auctioning Rs 3,500 crore of 91-day and Rs 2,500 crore of 182-day T-bills this week including Rs 3,000 crore of 91-day and Rs 2,000 crore of 182-day T-bills under MSS.

Corporate bonds saw five-year benchmark bonds rally by over 20 bps week on week as the market bought into higher spreads on good liquidity and on positive sentiments.

The five-year AAA bonds were quoting at 9.10%-9.15% levels.

The five-year AAA spreads closed at around 125 bps levels down almost 20 bps week on week.

Credit spreads are likely to take direction from policy review of the RBI.

Overnight index swaps (OIS) saw swap yields move down on the back of positive bond market sentiments.

The one-year OIS yield fell  7 bps to close last week at 6.97% levels. The five-year OIS yield closed down 12 bps at 7.14% levels.

The one over five spread closed at 17 bps, lower by 5 bps week on week. The policy review is expected to determine the direction of swap yields.

The author is head, portfolio management services, Sundaram BNP Paribas AMC Ltd. The views expressed by the author are his own and need not represent the views of the organisation in which he works.