RBI OMO bond sales will prompt selling in the bond market and yields could rise 10bps to 15bps if the market views the OMO as a yield signal. However, there will be buying at higher yields given the improved fundamentals for government bond yields.
RBI has announced an OMO (Open Market Operations) sale of Rs 100 billion of government bonds on the 13th of October. The bonds to be sold are 8.07% 2017 bond, 8.79% 2021 bond, 8.33% 2026 bond and the 8.28% 2027 bond. The current traded levels of the bonds as of 8th October are 8.07% 2021 – 8.33%, 8.33% 2026 bond- 8.65% and 8.28% 2027 bond- 8.65%. The 8.79% 2021 bond is not traded frequently and indicative yield would be around 8.63% levels.
Bond yields have fallen over the last couple of months on falling inflation expectations, improved government finances, lower oil prices and easing liquidity conditions. Inflation as measured by the CPI (Consumer Price Index) is trending at levels of 7.8% and is expected to stay down going forward on the back of lower oil prices. Global crude oil prices are trading at two year lows on the back of rising oil supply amidst uncertain global economic outlook. Read our report on US shale oil dynamics to understand rising oil supply. The IMF has cut global growth forecasts on the back of weakness in the Eurozone and worries on China growth prospects. Read our Global Economic Data Analysis for September 2014 for Eurozone and China data.
The government is running a cash surplus of over Rs 1000 billion and that has enabled a cut in borrowing for fiscal year 2013-14 by Rs 80 billion. The government had bought back Rs 200 billion of bonds in September to use its cash surplus. Liquidity has eased in the system on the back of RBI buying USD. Structural liquidity has become positive. Read our Liquidity Cheat Sheet for Liquidity Analysis.
Why is the RBI selling bonds?
The bond market has got used to RBI buying bonds through OMOs (Open Market Operations) over the last six years. RBI has bought bonds for Rs 5850 billion from fiscal 2008-09 to fiscal 2013-14 to infuse liquidity into the system and to support government borrowing that ballooned when the government took to fiscal measures to boost the economy post the 2007-08 global financial crises. Watch our Video on RBI OMO and Government Borrowing to know more about RBI bond buying operations.
The market now has to contend with the RBI starting to sell bonds from its books through screen based OMO. RBI has sold Rs 118 billion of government bonds in the May to September 2014 period through the NDS OM (Negotiated Dealing System Order Matching). The amount by itself is not large in relation to the Rs 5850 billion of purchases that RBI has done over the years but the context of selling is more important.
Why is the RBI selling bonds and will it continue to sell bonds throughout the year? Bond sales of RBI have implications on market sentiments that in turn affect bond yields. Is the RBI selling bonds to suck out system liquidity as a form of sterilization? The central bank has bought USD 15.75 billion in the April to July 2014 and indications are that it is continuing to buy USD both in spot and forward markets.
Buying of USD infuses liquidity into the system and RBI could be selling bonds to take out the liquidity infused through USD 15.75 billion plus of purchases.
The central bank has cut SLR (Statutory Liquidity Ratio) of banks by 1% of NDTL (Net Demand and Time Liabilities) over the last two policy reviews in June (0.50%) and August (0.50%). SLR cut frees liquidity for banks that otherwise would have gone for purchase of government bonds. 1% of SLR cut amounts to Rs 750 billion of liquidity freed for banks. RBI could be selling bonds to part sterilize the liquidity released by SLR cut.
The system liquidity has largely been in deficit despite RBI USD purchases and SLR cuts. Banks have been borrowing from the RBI through LAF (Liquidity Adjustment Facility) repo and term repo auctions, an average of around 0.5% of NDTL that is around Rs 350 billion on a daily basis. One of the reasons for liquidity still being in deficit mode is the surplus cash that the government is running with the RBI.
Government surplus with the RBI has ranged from Rs 400 billion to over Rs 1500 billion over the last few months. This is acting as natural liquidity sterilization against RBI USD purchases and SLR cuts. However the government will not continue to run surplus balance with the RBI and will start spending to pull up economic growth.
Given that system liquidity adjusted for government surplus would be in excess rather than in deficit, RBI could be selling bonds to take out this excess.
One question the market always has in mind when RBI sells bonds is whether it is a yield signal. The central bank usually does not have any particular level of bond yields that it targets and only intervenes in bond markets when there is extreme volatility on both sides. RBI has largely been present in the liquid part of the yield curve, which are the on the run traded bonds as that does not distort yields too much. Hence, RBI bond sales should not be construed as a yield signal.
RBI bond sales and SLR cuts do not go together as the latter is seen as affecting demand for government bonds by banks. The government is supplying bonds every week through bond auctions of Rs 150 billion each auction. RBI selling bonds and banks demand for bonds coming off on SLR cut, the market would naturally tend to sell bonds on worries of auction supply off take.
In the short run, continuing sale of bonds by RBI would be negative for bond yields but going forward if there is enough demand in the system for government bonds, RBI sales would not affect the yield trend. Demand for government bonds would naturally have to come from lower inflation expectations, falling trend in fiscal deficit and good system liquidity.