Yield curves are not toeing RBI’s line
Yield curves are not toeing RBI’s line of inflation rising and growth remaining steady. The current flat to inverted shape of the yield curve across fixed income securities, suggest that both inflation and growth will come off. RBI in its policy review in July raised the repo rate by a higher than expected 50bps to bring down rising inflation expectations. The RBI raised March 2011 forecast for inflation by 1% from 6% to 7% while maintain GDP growth forecast at around 8% levels.
Yield curve is the plotting of yields across maturities of bonds having similar credit characteristics. The government bond yield curve, the corporate bond yield curve and the interest rate swap yield curve are all flat to inverted. The normal theoretical shape of the yield curve is upward sloping as investors demand higher yields for longer maturity bonds to counter inflation risks in the longer term. Yield curves in a growth economy are typically upward sloping as bond investors factor in growth led inflation in long bond yields. The move away from normal implies that fixed income investors are not demanding higher yields for longer maturity bonds to compensate for inflation risks. In fact the sharp inversion in the interest rate swap curve suggest that RBI will actually start cutting policy rates in the first half of fiscal 2012-13. The charts below show the shape of yield curves for government bonds, AAA rated corporate bonds and OIS (Overnight Index Swap yields)
The one year, five year and ten year maturity government bond yields are all trading between 8.4% to 8.5% levels. The yield curve is flat for government bonds. The government is borrowing Rs 12,000 crores on a weekly basis with issues being concentrated in the ten and eleven year segment of the yield curve. The market is buying ten year government bonds at almost the same yield as of the one year government bonds. One year yields are reflecting RBI rate hikes and tight liquidity situation (market is borrowing from the RBI at repo rates of 8% on a daily basis). Ten year yields, while trading at multi year highs, are reflecting inflation coming off down the line as investors demand for ten year bonds in the auctions are steady.
Corporate bonds are trading at around 9.5% levels for two, five and ten year maturity bonds while one year corporate bonds are trading at 9.7% levels. One year corporate bond rates at 9.7% levels reflect tight liquidity conditions. Investors are buying five and ten year corporate bond yields at 9.5% levels indicating that absolute levels of yields at the longer end of the curve are attractive. Investors hope to gain from yields trending down at the longer end of the corporate bond curve.
The swap market is more conclusive in its judgment of inflation. Five year OIS (Overnight Index Swap) yields are trading at 80bps below one year OIS yields. In fact after the policy rate hike by 50bps, five year OIS yields closed the week at levels below pre policy levels. Five year OIS yields are trading at below 8.5% levels while one year OIS yields are trading at 8.3% levels. One year swap yields are betting on the RBI continuing its tight money policy while five year swap yields are indicating that RBI by tightening in the short term is setting up conditions to start loosening monetary policy in the longer term.
The market seems to have more faith in the RBI than RBI itself. If the market was worried on inflation overshooting targets, yields curves will be steep with long maturity bonds and swaps trading at levels much higher than short maturity bonds and swaps.
The last time the yield curve was inverted was just before the credit crisis hit the market in 2008. Post the crisis, bond yields came, inflation fell and growth came off. RBI had hiked policy rates sharply to bring down inflation expectations which, were trending at over double digit levels in mid 2008. Repo rates were at 9% levels before coming down all the way down to 4.75% as the RBI cut rates on falling inflation and growth expectations. Yield curves at present are factoring in a similar situation down the line.