The uncertainty on fuel price hikes over, bond yields will continue its downward trend. Bond yields have come off over the last couple of weeks with the yield on the benchmark ten year bond the 7.80% 2021 bond falling by 20bps from highs of 8.45% to levels of 8.25%. The yield is likely to fall further as the fuel price hikes and the duty cuts puts paid to question marks on inflation and government finances.
Inflation as measured by the WPI (Wholesale Price Index) will be impacted by 60bps directly by the fuel price hikes. On an indirect basis fuel price hikes will take up costs of goods and services in the economy. Net to net inflation for the month of June 2011 (to be released mid July) is likely to come in much higher than the levels of 9.06% seen in the month of May 2011. Inflation can even come in at double-digit levels, though the recent fall in commodity and oil prices globally can temper the rise. Commodity prices have fallen by 4.6% month to date with the Reuters CRB commodity index falling from levels of 346 to levels of 330. Oil prices have fallen by 9% month to date with Brent crude prices falling from levels of USD 115/bbl to levels of USD 105/bbl. Commodity prices have fallen due to worries on global economic growth with the US Federal Reserve (Fed) reducing US growth forecast for this year from 3.1% – 3.3% to 2.7% – 2.9%. Economies in the Eurozone are facing headwinds due to forced cut down in consumption as debt ridden governments impose austerity measures to cut down deficits. China too is bringing down its growth as the government and the central bank takes measures to bring down rising inflation expectations. The bond market will look at the spike in inflation for the month of June as a one off rise and look forward to where inflation is headed down the line. Given that growth forecasts are being revised downwards and commodity prices have corrected and are likely to stay corrected for a while, inflation is expected to come off from higher levels.
Government finances too are becoming clearer after the fuel price hikes and duty cuts. The duty cuts will impact budgeted revenues by Rs 50,000 crores and the government is most likely to make up this shortfall by resorting to higher borrowings. The fuel price hikes and the custom duty cuts will bring down projected oil marketing companies (OMCs) losses by Rs 50,000 crores from Rs 170,000 crores to Rs 120,000 crores. There is uncertainty on how the government will compensate the OMCs for the losses. The government is not likely to resort to higher borrowings to pay the subsidy bill, and the market can go with a Rs 50,000 crores higher borrowing number. Higher borrowing will take place in the second half of this fiscal, which is also the period when inflation is expected to come off and RBI changes policy stance from anti inflationary to neutral.
Liquidity conditions are expected to ease in the coming weeks. The market can expect Rs 55,000 crores coming into the system in the next one month in the form of maturities of bonds and cash management bills. Government spending of the money collected in advance tax payments of over Rs 35,000 crores will add liquidity to the system. The fuel price hikes will also have its impact on credit growth, which is likely to come down as oil companies borrowing comes down. Rising liquidity levels will have a positive impact on bond yields.
Yield Curve Movement
Government bond auction
The government auctioned Rs 12,000 crores of bonds last week. The bonds auctioned were the 7.59% 2016 bond for Rs 3000 crores, the 8.08% 2022 bond for Rs 6000 crores and the 8.28% 2032 bond for Rs 3000 crores. The cut offs came in at 8.34%, 8.35% and 8.60% respectively. The government is scheduled to auction Rs 15,000 crores of bonds this week.