The world was watching the US Federal Reserve chairman Ben Bernanke on Friday on whether he would signal a third round of bond purchases. Bernanke did not give any hints of Q3 (third round of quantative easing) in his speech in Jackson Hole and forecast that the US economy will see better growth in the second half of this calendar year. Equities rallied with US equity indices closing up over a percent on the Fed’s optimism on the economy. Bond yields in the US fell by 10bps as inflation fears went out on the back of no bond purchase signal by the Fed. Bernanke did say that US economic growth is sluggish and unemployment at 9.1% is an issue and that the Fed will do all it can to spur economic growth. The Fed meeting in September has been extended by 1 day and has the market speculating on what will go on in the meeting.
Fixed income traders in India will heave a sigh of relief on the lack of announcement of a Q3 by the Fed. Bond market is worried about the continued hawkish tone of the RBI on inflation and a Q3 announcement would have caused a sell off in bonds (yields would have gone up). The bond market went cautious into the Fed speech last week, with bond yields rising by around 3bps to 6bps on trader selling. The market also sold bonds after the release of the RBI annual report for 2010-11, where it stated that inflation is the predominant concern of the RBI and tight monetary policy stance will continue for a while. Average annual inflation as measured by the WPI (Wholesale price Index) for 2010-11 at 9.6% was the highest in the last ten years. There are also worries on government finances with oil under recoveries for 2011-12 seen at Rs 121,000 crores while the government has budgeted for just one third of the total expected undrerecoveries. The weak equity markets where domestic equity indices are down by over 15% from highs seen during this years is preventing the PSU (Public Sector Units) disinvestment process of the government. The government has budgeted for Rs 40,000 crores from sale of shares.
The market will get over the negatives of RBI stance and government finances and look to take down bond yields on the back of weakening economic growth. Ten year benchmark bond yields are trading at 8.30% levels, down from highs of 8.45% seen in July 2011. Ten year yields at 8.30% is still close to multi year highs and given expectations of both growth and inflation coming off down the line, the yields are likely to trend down sooner than later. RBI has projected inflation coming off towards December 2011 and the markets will start front running that prospect. The fact that government borrowing for the first half of this fiscal is coming to a close with only a couple of auctions left is also a positive for the markets. The government will stick to its budgeted borrowing for this fiscal in announcing the borrowing calendar for the second half of this year and any slippages in budgets will be made up through bond auctions post January 2012.
The swap market saw the five over one OIS (Overnight Index Swap) spread flattening by 7bps week on week. The five over one OIS spread has inverted from a positive 55bps in April this year to a negative 85bps as of 26th August. The sharp inversion in the swap spreads suggests that RBI policy stance will bring down inflation and growth. However, at current levels of inversion, the market will look to play for a flattening of the spread and as the market goes into the RBI policy review in mid September, the spread will flatten further. The swap market will start front running RBI holding on to policy rates in this review.
Money market security yields fell with one year bank CD (Certificate of Deposit) rates falling by 10bps week on week. Banks are reluctant to issue paper at higher yields given that they are going slow on credit on the back of rising NPA (Non Performing Asset) worries. Major PSU banks including SBI has made large provisions in the last quarter for bad loans and given the current state of capital markets, PSU bank loans are forecast by analysts to rise further. Banks will incrementally start parking excess liquidity in government bonds. Money market security yields will come off further as banks refrain from raising liquidity at higher levels of yields.
Government bond auction
The government auctioned Rs 11,000 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 8.28% 2027 bond for Rs 2000 crores. The cut offs came in at 8.34%, 8.30%, and 8.58% respectively. The government is scheduled to auction Rs 11,000 crores of bonds this week.