Pre-policy rate hike to be positive

The deregulation of petrol prices and the hikes in diesel, LPG and kerosene rates by the government has prompted the bond market to price in an earlier-than-expected policy rate hikes by the Reserve Bank of India (RBI).

The fuel price hike is expected to push June 2010 inflation to double digit levels, the third consecutive month of double digit inflation. The high trending inflation expectations is expected to push the RBI into raising policy rates before its first quarter policy review meeting on July 27. A pre-policy rate hike will be followed by a rate hike in the policy review, leading to expectations of a minimum 50 basis points (bps) hike in the reverse repo and repo rates in the coming one month.

The rate hikes by the RBI is a positive for the market as the curves have priced in the hikes and once the event is over, the market can start looking forward. Ten-year benchmark bond yields at 7.64% levels are trading at a spread of over 200bps over the repo rate of 5.25% (the current benchmark rate given negative system liquidity). A 50bps hike in repo rates will bring the spread down to 150bps (assuming liquidity remains negative for a while).

A rate hike at this juncture is purely a one or two day sentiment driver and is not a major factor in determining long bond yields.
The outlook for long bond yields is positive, given expectations of a slowdown in global economic growth, prospects of domestic inflation expectations trending down on slowing money supply growth, and improved government finances post telecom spectrum auctions.

Global bond yields are starting to factor a slowdown in global growth as Eurozone governments cut budget deficits and China reins in lending to curb excessive speculation. US treasuries, German bunds and even UK gilts (the worst of the lot in terms of public debt) are trading at close to one-year lows on prospects of slow economic growth. Central banks are expected to maintain rates at all time lows on the back of lower growth and lower inflation expectations.

The hike in cash reserve ratio (CRR) by the RBI, coupled with slowing down of bank deposit growth (trending at 14.3% year on year as of June 4, 2010 against 22% levels seen in the same period last year), has resulted in money supply growth slowing down. Broad money supply growth is trending at 14.6% against 20% seen in the previous year. The slowing down of money supply growth is likely to keep liquidity at reasonable levels.

The government has collected Rs 105,000 crore in the 3G and broadband spectrum auctions against the budgeted Rs 35,000 crore. This will enable the government to stick to its deficit targets even if there are strains in other sources of revenues or if there are higher than expected expenditures.

Liquidity, as measured by bids for reverse repo/ repo in the liquidity adjustment facility (LAF) auction of the RBI, was strained, with bids for repo averaging Rs 70,000 crore last week.
Liquidity is expected to stay tight as there is no visibility of large inflows into the system in the next fortnight. Overnight rates will continue to trade around repo levels.

Government bonds
Yields closed higher week on week on the back of worries of rate hikes. The benchmark ten-year bond yield closed up 6 bps at 7.64% levels. The 7.17% 2015 yield rose 20 bps to 7.40% levels. The yield on the 8.20% 2022 gained 5 bps to 7.98%, while the 8.28% 2032 closed up 7 bps at 8.29%.

The government auctioned Rs 15,000 crore of bonds last week — Rs 5000 crore each of the 7.17% 2015 and the 7.80% 2020, Rs 2000 crore of the 8.26% 2027, and Rs 3000 crore of the 8.28% 2032. The cut-offs came in at 7.40%, 7.62%, 8.20% and 8.27%, respectively. Bond yields are likely to be choppy on rate hike worries.

Treasury bills, corporate bonds and overnight index swaps
Treasury bill (T-bill) yields were flat in the 91-day auction last week, with the cut-off at 5.36%, little changed from the previous auction. The 182-day auction saw the cut-off at 5.37% against 5.25% at the previous auction. The RBI is auctioning Rs 2,000 crore of 91- day and Rs 1,000 crore of 364-day T-bills this week.
Corporate bond yields rose on rate-hike fears. Five- and ten-year benchmark AAA bond yields closed up 5 bps each at 8.26% and 8.75%, respectively. Yields are likely to remain pressured on account of rate-hike fears and tight money conditions.

The overnight index swaps (OIS) curve moved up on the back of rate-hike worries. The five-year OIS yield closed 2 bps higher at 6.80% while the one-year OIS yield closed 15 bps higher at 5.57%. The one-over-five spread closed down 13 bps at 123 bps. The curve will continue to flatten as the long end mirrors fall in US swap yields while the short end factors in tight liquidity and rate hikes.

The writer is head, fixed income, IDFC Mutual Fund. Views are personal.