The ten year benchmark gsec yield is expected to hover in a range of 6.75% to 7.15% in the most part of 2017. There will be undershoots or overshoots to the range as markets react to various dynamic factors but the overall direction of yields is higher from current levels of 6.55%.
The ten year benchmark gsec yield had a good run in calendar year 2016 with yields falling by 125bps from levels of 7.80% to 6.55% as of 23rd December 2017. The new benchmark ten year bond, the 6.97% 2026 bond that was issued in September 2016 has seen yields drop by 42bps since issuance. However the yield on the 6.97% 2026 bond has climbed by 40bps in the month of December as RBI held rates in its policy review against market expectations. Chart 1.
Given the strong run of the ten year gsec yield in 2016 and the fact that the yield has backed up from lows in December 2016, what is the outlook for the yield in 2017? Where will the yield close in 2017 from current levels of 6.55%?
The factors to consider for the ten year gsec yield in 2017 are both global and domestic. The domestic front looks better than the global front for the yield but that would not drive down the yield. The reason is that the RBI is more likely to stay put on rates in 2017 while the government will look to pump prime the economy in the next fiscal year to push up economic growth that will see a couple of quarters of lower growth due to demonetization. The government will not have to increase the fiscal deficit to pump prime the economy as it will have enough funds from black money eradication / disclosures due to demonetization.
On the domestic front, markets will expect higher growth, stable fiscal deficit and inflation expectations at around 5% and above, which is well within RBI’s target of 4% +/- 2%.
The global front looks more negative for bond yields. The US economy will see fiscal pump priming by the Trump administration even as the Fed hikes rates to bring rates on par with higher inflation expectations. US unemployment rate at 4.7% is tight and if economy grows faster, will lead to wages rising leading to higher inflation in the economy.
The ECB too will stop bond purchases at the end of 2017 and may look to start raising rates starting 2018 if Eurozone economy picks up and inflation moves closer to ECB’s target of 2% from current levels of 0.8%. Eurozone unemployment rate has fallen from levels of 12% to levels of 9.8% over the last couple of years indicating a slow recovery in labour markets and economic growth.
The year 2017 is expected to see markets move away from safe haven bonds on expectations of stronger global economic growth led by the US. However, given that China is still expected to grow at a slower pace of 6.5% to 7%, inflationary pressures driven by commodity prices will be low and that will keep bond yields steady once they have peaked out at levels comfortable for economic growth.
The ten year benchmark bond, the 6.97% 2026 bond saw yields rise by 4bps week on week to close at levels of 6.54%. The old ten year benchmark bond, the 7.59% 2026 bond saw yields rise by 4bps to close at 6.70% levels while the 7.88% 2030 bond and the 8.13% 2045 bond saw yields rise by 9bps and 10bps respectively to close at levels of 7.02% and 7.21%. The widening spread between the ten year and longer bond yields indicate bearish market trends and yields could rise further from current levels.
OIS market saw one year OIS yields close up by 2bps and five year OIS yields close up by 2bps week on week. One year OIS yield closed at 6.24% while five year OIS yield closed at 6.32%. OIS yield curve will steepen as markets factor in faster pace of Fed rate hikes.
Credit spreads closed mixed last week. Three-year benchmark AAA corporate bond yields closed higher by 5bps week on week at 7.08% levels. Credit spreads rose by 3 bps to close at 67bps levels. Five-year benchmark AAA bond yields rose by 5bps to close at 7.33% with spreads up by 1bps at 63bps levels. Ten-year benchmark AAA bond yields fell by 3bps to close at 7.43% levels with spreads down by 7bps at 78bps. Credit spreads are likely to go down, as corporate bonds turn sticky at higher levels of yields.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) and MSS bond issuance was in surplus of Rs 6745 billion as of 23rd December. The surplus was Rs 6452 billion in the week previous to last. MSS bonds outstanding were Rs 5499 billion. Government surplus was Rs 112 billion last week.