The brief rally in bond yields fizzled out on the back of fresh worries on inflation, government finances and rate hikes. The ten year benchmark bond the 7.80% 2021 bond saw yields fall by 15bps during last week before climbing back to close the week with yields marginally down week on week. The ten year bond is trading at levels of 8.29%, down from peaks of 8.45% seen in the beginning of August but up from lows of 8.15% seen last week. The market is at crossroads now and does not know which road to take given different forces moving in different direction to each other. There are both positives and negatives for bond yields, and that will cap yields from rising back to 8.45% levels and yields from falling significantly below 8.15% levels. The tide however seems to be turning in favor of bond yields and if the tide picks up bonds yields can trend significantly down from current levels of 8.29% on the ten year bond.
The US rating downgrade has changed the outlook for global economies. The US Federal Reserve (Fed) has pledged to keep US policy rates at all time lows for the next two years given headwinds for the US economy in the form of sticky unemployment levels and lower government spending. Inflation too is expected to see a downward trend according to the Fed. The ECB (European Central Bank) is fighting to keep the system stable after a sell off in sovereign bond yields of Eurozone countries. China is curbing growth to ward of inflation that threatens the social stability of the economy. India is facing a slowdown driven by high interest rates, rising inflation and weak investment sentiments.
In a world facing growth slowdown, bond yields should benefit with inflation expectations coming off and central banks maintaining accommodative policy. US ten year treasury yields have come off by 120bps since April 2011 on the back of worries on US growth. Bond yields in Germany, UK and Japan are trading at year lows. The fall in bond yields globally has filtered into the interest rate swap yields in India. Five year OIS (Overnight Index Swaps) yields are trading at one year lows of 6.85%, down by 160bps from highs seen in May 2011. The sharp fall in five year OIS yields suggest that swap traders are betting heavily on growth and inflation coming off, and RBI will be forced to start cutting rates sooner than later.
The optimism of swap traders is not reflected in government bond yields. Ten year bond yields are just off by 15bps from highs seen during this year. Bond traders and investors are worried on further rate hikes by the RBI and on government finances. The RBI, despite signs of growth and inflation coming off is maintaining an hawkish stance on inflation. Government finances are weak with the government overdrawn by Rs 50,000 crores with the RBI as of 5th August 2011. This overdraft can come back to the market in the form of dated government bond auctions.
The market has to decide which road to take. The path towards monetary policy turning neutral sooner than later is the more attractive one given weakening signs of factors affecting inflation.
Inflation as measured by the WPI (Wholesale Price Index) is expected to come in at 9.2% for the month of July 2011 against 9.44% for June 2011. The IIP (Index of Industrial Production) growth for the month of June came in at 8.8%, much above market expectations of 5.7%. The IIP growth number is clouded by a volatile capital goods index data, which has swung violently in recent months. Capital goods index growth came in at 37.7% for June against 6.1% growth in May.
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 8.30% 2040 bond for Rs 3000 crores. The cut offs came in at 8.29%, 8.28%, and 8.59% respectively. The government is scheduled to auction Rs 10,000 crores of bonds this week. The government auctioned Rs 6000 crores of 49 days cash management bills last week. The cut off came in at 8.29%.