The Interest Rate Swap (IRS) market is usually a front runner for bond yields. The sharp fall in five year OIS (Overnight Index Swaps) yields indicates that bonds yields are in for a sharp rally too. Five year OIS yields closed last week at 7.70% levels down 20bps week on week and 60bps month on month. The benchmark ten year bond the 7.80% 2021 bonds closed last week at 8.23% levels down 3bps week on week and almost flat month on month. Chart 1 gives the movement of ten year bond yield and five year OIS yield over the last two months.
The ten year bond and the five year OIS yield movements suggest that the ten year bond follows the direction of the five year OIS, with a lag. Hence the sharp fall in five year OIS yields does suggest an impending rally in the ten year bond yield.
The swap market being a leveraged market reacts the quickest to expected events. Swap yields moved up sharply when the RBI hiked the repo rate by 50bps in May. The sharp upward movement in swap yields after the rate hike was due to the fact that the market was expecting more rates hikes by the RBI on the back of rising inflation expectations. The reversal in yields with the five year OIS yield falling by 60bps month on month is a sign that the market is now betting on the RBI maintaining status quo on rates in the mid quarter policy review on the 16th of June. Swap yields are unlikely to react negatively even if the RBI raises rates by 25bps as the market will take it as the last of the rate hikes. Swap yields will react negatively if RBI raises rates and signals further rate hikes ahead.
I have been saying in my columns that rates hikes are over and done with. The 50bps hike in May has given the RBI room to study factors that affect inflation and inflation expectations. The RBI hedged their bets on inflation by forecasting that inflation as measured by the WPI or Wholesale Price Index will print at higher levels (close to 9% levels) in the first six months of the 2011-12 fiscal. Fuel price hikes and high oil prices are unlikely to alter RBI’s judgment on inflation.
The factors driving inflation are not apparent at present. Global economy is showing signs of slowdown with unemployment in US continuing to stay at 9% levels, China rate tightening in the face of inflation taking its effect on China’s growth expectations and Euro Zone sovereign debt issues gaining ground to affect Euro Zone growth. India’s IIP (Index of Industrial Production) growth for April 2011 came in at 6.3% (4.4% old series). The index contracted by 1% month on month. Vehicle sales growth at a twenty month low in May 2011 is indicating that rate hikes and inflation are taking their effect on consumer demand. Central banks of the Euro Zone, Australia and Korea have all put rate hikes on hold on slowing growth signs. The RBI will follow suit and maintain rates status quo while stating that containing inflation expectations will still be its primary objective.
Liquidity and inverted yields curves are also helping the RBI in monetary transmission. Liquidity continues to stay in a deficit mode with the system borrowing from the RBI on a daily basis. Tight liquidity conditions is keeping short end rates high with one year borrowing costs for banks at close to 10% levels. Banks have hiked lending rates in the face of high borrowing costs leading to consumer demand cooling off.
Global economy, domestic liquidity and interest rates are all in favour of inflation coming off. The RBI has enough reasons to stay with current policy rates.
Government bond auction
The government auctioned Rs 12,000 crores of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs 3000 crores, the 7.80% 2021 bond for Rs 6000 crores and the 8.26% 2027 bond for Rs 3000 crores. The cut offs came in at 8.30%, 8.25% and 8.59% respectively. There are no government bond auctions scheduled for this week.
Table 1. Weekly Movement in Fixed Income Markets
|Government Bond Yields||03-06-2011||10-06-2011||Change in bps|
|Average Traded volumes NDS OM Rs crores||11400||12500||1100|
|Liquidity Rs crores||03-06-2011||10-06-2011||Change|
|Average Reverse Repo Bids||500||25||-475|
|Average Repo Bids||-44000||-75000||-31000|
|Overnight Index Swap Yields||03-06-2011||10-06-2011||Change in bps|
|T-bill auction yields||01-06-2011||08-06-2011||Change in bps|
|91 day T-bill||8.19%||8.23%||4|
|182 day- T-bill||8.27%||8.24%||-3|
|364 day T-bill||8.30%||8.30%||0|
|Credit Yields||03-06-2011||10-06-2011||Change in bps|
|1 Year CD||10.05%||9.95%||-10|
|2 year AAA||9.80%||9.75%||-5|
|5 Year AAA||9.64%||9.60%||-4|
|10 Year AAA||9.68%||9.60%||-8|
|source: CCIL, RBI|
Source:CCIL, RBI, Market Quotes