Bond yields trended down last week on the back of weaker than expected IIP (Index of Industrial Production) growth data and softer than expected inflation data. Bond yields will continue to trend down on expectations that RBI policy stance will turn neutral from hawkish in the policy review at the end of July. The market is divided between a 25bps rate hike and no rate hike, but there is a consensus building, that even if there is a rate hike it will be the last for a while. Benchmark ten year bond yields closed last week at 8.27% levels, down 8bps week on week.
IIP growth for the month of May 2011 printed at 5.6% year on year. IIP contracted by 3.1% on a month on month basis, following April’s month on month contraction of 1.6%. Manufacturing growth for May contracted by 4.2% on a month on month basis. Weakness in the IIP growth numbers for the first two months of this fiscal does not portend weakness for the full year, but given that interest rates are at three year highs the RBI will take the weakness in IIP as a sign of policy rate transmission.
Inflation, as measured by the WPI or Wholesale Price Index, for the month of June 2011 came in at 9.44% against market expectations of 9.68%. Inflation has not peaked out yet, as June fuel price hikes will be felt in the July numbers, but given that non food manufacturing index has gone up by 0.2% month on month against 0.8% for the overall index, the July inflation number is likely to be the peak of inflation. Unless there is sharp surge in global commodity prices and domestic food prices, inflation is most likely to trend down from July peaks. The weak IIP growth numbers indicate further weakness in non food manufacturing inflation down the line.
Corporate bond yields came off sharply week on week with one year yields falling by almost 30bps on the back of easing system liquidity. Liquidity has eased considerably with bids for repo at 7.5% in the LAF (Liquidity Adjustment Facility) auction conducted by the RBI averaging Rs 12,000 crores on a daily basis. Banks were borrowing around Rs 70,000 crores from the RBI on daily basis last month. Easing liquidity and signs of interest rates coming off have benefitted corporate bonds the most. Corporate bond yields came off by 15bps week on week across the curve. Five and ten year AAA credit spreads (difference between corporate bond and government bond yields) came off by 10bps each week on week. Five and ten year credit spreads closed at 95bps each last week. Credit spreads will remain soft on the back of improving liquidity and interest rate scenario.
Swap rates fell sharply on the back of a better outlook for liquidity and interest rates. Five year OIS (Overnight Index Swaps) yields fell 30bps week on week while one year OIS yields fell 22bps week on week. The five over one spread inverted by 4bps to close the week at 41bps levels. Swap spreads are unlikely to invert further and will start to flatten once RBI is through with the policy review in July.
Government bond auction
The government auctioned Rs 12,000 crores of bonds last week. The bonds auctioned were 7.83% 2018 bond for Rs 3000 crores, the 7.80% 2021 bond for Rs 6000 crores and the 8.30% 2040 bond for Rs 3000 crores. The cut offs came in at 8.28%, 8.25%, and 8.59% respectively. The government is scheduled to auction Rs 12,000 crores of bonds this week.