Crisis of confidence in Fixed Income Street

Government bond yields grudgingly went down by a few basis points week on week on the back of a plunge in global yields and commodity prices.

When the US Federal Reserve did not announce a third tranche of quantitative easing or QE3 (bond purchases), risk assets were routed as investors fled to the safety of US treasuries and the dollar following worries of slowing economic growth.

The ten-year benchmark US treasury yields fell to record low 1.72% last week after the Fed announced a $400 billion longer maturity (six to thirty years) bond purchase program to replace short maturity bonds in the Fed’s books.

The so-called ‘Operation Twist’ will keep its balance sheet size constant.

The dollar index moved up by close to 2.5% week on week as investors piled on to the greenback in a risk-aversion trade.
Commodity prices moved down sharply with the Reuters CRB index diving over 8% week on week as demand worries set in.

The risk aversion trend is a positive for Indian bond markets as lower commodity prices will bring down inflation expectations and worries on economic growth will prompt the Reserve Bank of India (RBI) to shift the monetary policy stance from tight to neutral.
But traders are not buying the argument, and are instead focused on the sharp fall in the rupee against the dollar.

The rupee has lost over 10% against the dollar since the beginning of August. Traders are worried that a weak rupee will negate the fall in global commodity prices and that RBI intervention by selling dollars will suck out liquidity from the system.

The street does not have the confidence to take large directional calls with bond yields trending down.

Liquidity has been tight for over a year and a quarter with the market borrowing from the RBI on a daily basis to meet liquidity needs.

Bond yields have been on a sustained upward trend in over a year as inflation has continuously overshot estimates and the RBI has been raising rates consecutively for thirteen months to bring down inflation expectations.

Government finances, which were in surplus last year, have been continuously in deficit since the beginning of this fiscal. The market is worried about the government overshooting its budgeted borrowings for this fiscal due to subsidy bills trumping estimates by four times.

The fixed-income market requires a dose of confidence that can only come from headline inflation numbers coming off from current levels of 9.78% on a sustained basis.

The market also requires a couple of RBI monetary policy reviews where policy rates are not hiked.

Clarity on government borrowing is another imperative as perennially-in-deficit government finances indicate higher than budgeted borrowing for the second half of this fiscal.

Until confidence returns, yields will find it difficult to trend down on a sustained basis. However, peaks have been seen for the present with ten-year benchmark peaking out at 8.45% levels by July-end.

The yields on the 7.80% 2021 bond at 8.30% levels will trade in a 8.15% to 8.35% range until the animal spirits are back.
Global risk aversion took down interest-rate swap yields with the one- and five-year OIS (overnight index swap) yields falling by 9 basis points (bps) and 10 bps week on week, respectively.
Five-year OIS yields closed last week at 6.80% levels, while the one-year OIS yields closed at 7.79% levels.

OIS yields are likely to remain soft given record low rates in the US.

Corporate bond yields were almost unchanged on liquidity worries, leading to credit spreads moving up. 5- and 10-year AAA credit spreads moved up by 11 bps each to close to 104 bps and 102 bps, respectively. Liquidity worries will keep credit spreads pressured.

Government bond auction
The RBI auctioned state development loans (SDL) for `4,100 crores last week. The cut-offs for various ten-year state loans came in at 8.65%-8.66% levels.

— The writer is editor, www.investorsareidiots.com, a website for investors