Five year interest rate swaps are frontrunning government bond yields
Invest in government bonds or gilt funds
The five year OIS (Overnight index swap) is trading at 75bps below the five year corresponding government bond. The five year swap level is at 7.55% levels while the well traded 7.83% 2018 bond (the closest on the run bond in the absence of an on the run benchmark five year bond) is trading at 8.30% levels. The five year swap and the five year government bond were trading at negative to zero spreads in April and May before the swap broke out.
The question to ask is whether the five year swap is front running the five year bond? The answer is yes. The five year swap is factoring a slowdown in growth as well as inflation coming off while the five year bond is still living in fear of rate hikes and supply. The release of the IIP growth number for May 2011 strengthens the case of the five year swap. IIP growth for May came in at 5.6% levels, against market expectations of over 8% growth. The 5.6% growth for May is against an 8.6% growth seen in May 2010. Industrial production is reflecting a slowdown due to high interest rates, high inflation and sluggish capital markets.
The five year swap is also linked to the yield on the ten year US treasury. In the April- July period, the yield on the US ten year treasury fell by 60bps while the five year swap yield has also fallen by 60bps. The US treasury yield is factoring a slowdown in the US economy and has come off despite issues of an increase in US debt ceiling. A slowdown in growth in the world’s largest economy will hurt growth in India.
Inflation is expected to come in higher for the month of June against the 9.06% levels seen in May. Fuel price hikes by the government will feed into higher inflation numbers. However, the future course of inflation is not certain. Inflation will not trend higher if growth slows down, demand falls and global growth falls leading to fall in prices of commodities. The RBI is likely to pause in their rate hikes given current issues on domestic and global growth and on the fact that it has hiked rates cumulatively by 275bps over the last fifteen months.
Bond yields at close to three year highs, bond-swap spreads sharply up and sharp fall in IIP growth numbers all point towards a good bond rally.