The government is holding back a bond rally due to its reluctance to bite the bullet and hike fuel prices. Crude oil prices (Brent Crude) are higher by 23% calendar year to date, and the government is yet to pass on the rise to the consumer. As a result the government’s subsidy bill is increasing as it has to compensate oil marketing companies for their losses. Subsidy bill is estimated to cross Rs 175,000 crores if crude oil prices stay at current levels of USD 113/bbl and is not passed on to the end user. The government’s inaction also hampers RBI is arriving at a correct inflation forecast. The RBI is forced to take monetary steps as the government continues to subsidize fuel consumption. Subsidizing fuel consumption also defeats the whole purpose of RBI trying to cool off demand in the economy in the face of rising inflation expectations.
The market has everything going for it for a healthy rally from current levels. Inflation and rate hikes are on their last legs of negative surprises The ten year benchmark bond, the 7.80% 2021 bond is trading at levels of 8.26%, down 20bps from highs seen a couple of weeks back but higher by 40bps fiscal year to date (April 2011 to present). Bond yields rose on the back of worries of inflation, rate hikes and government borrowing. Inflation as measured by the WPI or Wholesale Price Index printed at 9.06% for the month of May 2011 with manufacturing inflation coming in at 7.3%, higher by 1.1% month on month. Given inflation printing at over 9% levels and given that inflation is yet to reflect the rise in crude oil prices, the RBI raised the benchmark policy rate the repo rate by 25bps in its policy review on the 16th of June. The RBI has guided for another 25bps hike in July signaling its focus on bringing down inflation expectations. Inflation will be impacted negatively if the government hikes fuel prices, but apart from that there are no great drivers for inflation in the current environment. The RBI has acknowledged that there are threats to global growth in the form of US unemployment, China rate tightening and Eurozone debt issues. The RBI has also taken note of fall in IIP (Index of Industrial Production) which printed at 6.3% for the month of April, a 1% contraction month on month. Unless inflation drivers of global growth and domestic demand flare up, inflation expectations will trend down rather that up. The market while factoring in another 25bps rate hike in July will expect monetary policy to turn neutral from tight in the coming months.
Government borrowing is expected to be higher than net budgeted levels of around Rs 340,000 crores. The rising subsidy bill will impact borrowing negatively in the second half of this fiscal. However, if the extra borrowing is not yield threatening the market will shrug it off. The healthy corporate advance tax numbers of Rs 30,000 crores (higher by 75% year on year) for the first quarter of fiscal 2011-12 is positive for market sentiments on government borrowing. Higher tax collections coupled with fuel price hikes (expected soon) will improve government finances and this improvement can sustain a bond rally.
Liquidity tightened towards the end of last week on the back of advance tax outflows of over Rs 30,000 crores. Bids for repo at 7.5% were at Rs 85,000 crores on the last two days of the reporting week, higher by Rs 35,000 crores from the average of Rs 50,000 crores seen in the first three days of last week. Liquidity is expected to come back into the system through maturity of cash management bills and bond maturities. Cash management bills of Rs 28,000 crores are outstanding and these will mature over the next one month. The maturity of 9.39% 2011 on the 2nd of July will bring in Rs 37,000 crores into the system. Liquidity while in a deficit mode, is not a cause for concern for the market.
Chart 2. Yield Curve Movement
Government bond auction
There were no government bond auctions held last week.
Table 1. Weekly Movement in Fixed Income Markets