Government bond yields grudgingly went down by a few basis points week on week on the back of a plunge in global bond yields and global commodity prices. The lack of an announcement of a fresh round of bond purchases (QE3 or Quantative Easing 3) by the US Federal Reserve (Fed) took down risk assets as investors fled to the safety of US treasuries and the US Dollar (USD) on worries of slowing economic growth. Ten year benchmark US treasury yields fell to record low yields of 1.72% last week as the Fed announced a USD 400 billion longer maturity (six to thirty years) bond purchase program to replace short maturity bonds in the Fed’s books. The Fed in carrying out “Operation Twist” will keep its balance sheet constant. The US Dollar index moved up by close to 2.5% week on week as investors piled on to USD as a risk aversion trade.
Commodity prices moved down sharply with the Reuters CRB index moving down by over 8% week on week as demand worries set in for commodities. The risk aversion trend is positive for Indian bond markets as lower commodity prices will bring down inflation expectations and worries on economic growth will prompt the RBI into turning monetary policy stance tight to neutral.
Bond traders are not buying the argument. Traders are instead focused on the sharp fall in the value of the Indian Rupee (INR) against the USD as markets sold off emerging currencies on risk aversion. The INR has lost over 10% against the USD since the beginning of August 2011. Traders are worried that a weak INR will negate the fall in global commodity prices and that RBI intervention in the markets to sell USD will suck out liquidity from the system.
The market does not have confidence to take large directional calls on bond yields trending down. Liquidity has been tight for over a year and a quarter with the market borrowing from the RBI on a daily basis to meet liquidity needs. Bond yields have been on a sustained upward trend in over a year as inflation has continuously overshot estimates and RBI has been raising rates consecutively for thirteen months to bring down inflation expectations. Government finances, which were in surplus last year, have been continuously in deficit since the beginning of this fiscal 2011-12. The market is worried of the government overshooting its budgeted borrowing for this fiscal due to subsidy bills overshooting estimates by four times.
The fixed income market requires a dose of confidence that can only come from headline inflation numbers coming off from current levels of 9.78% on a sustained basis. The market also requires a couple of RBI policies where policy rates are not hiked. Clarity on government borrowing is also required as a perennially deficit government finances indicate higher than budgeted borrowing for the second half of fiscal 2011-12. Until confidence comes in to the market, bond yields will find it difficult to trend down on a sustained basis. However, peaks have been seen for the present with ten year benchmark bond yield peaking out at 8.45% levels in end July 2011. The yields on the 7.80% 2021 bond at 8.30% levels at present will trade in an 8.15% to 8.35% range until confidence emerges in the market.
Global risk aversion took down interest rate swap yields with one and five year OIS (Overnight Index Swap) yields falling by 9bps and 10bps week on week respectively. Five year OIS yields closed last week at 6.80% levels while one year OIS yields closed at 7.79% levels. OIS yields are likely to remain soft given record low rates in the US. Corporate bond yields were almost unchanged on liquidity worries, leading to credit spreads moving up. Five and ten year AAA credit spreads moved up by 11bps each to close to 104bps and 102bps respectively. Liquidity worries will keep credit spreads pressured
Government bond auction
The RBI auctioned State Development Loans (SDL) for Rs 4100 crores last week. The cut offs for various ten year state loan auctions came in at 8.65%-8.66% levels.