The resurgence of global risk aversion is not filtering into domestic government bond yields. The fall in US and German bond yields to record low close of 1.92% and 1.77% respectively reflects deep concerns on sovereign credit risk of highly indebted nations such as Italy, Spain, Portugal, Greece, Ireland and even France to some extent. The depreciation of the Euro against the USD (US Dollar) suggests money flowing out of Eurozone into safe haven currencies such as the USD and the CHF (Swiss Franc). The Euro lost over 3.5% against the USD week on week while the Swiss National Bank had to pledge support to the Euro at CHF 1.2 to prevent the CHF from rising further. The German equity index fell over 6% week on week on the back of worries on the European banking sector, which has high exposure to Eurozone sovereign debt.
The risk aversion that drove down treasury yields in the US and Germany has not filtered into the Indian government bond yields. The ten year benchmark bond the 7.80% 2021 bond is trading at levels of 8.30%, up by 15bps from lows of 8.15% seen in August 2011. The ten year bond yield is trading at just around 15bps off year highs of 8.45% and is steadfastly refusing to come off. The interest rate swap market on the other hand is reflecting the fall in interest rates globally. The five year OIS (Overnight Index Swap) is trading at 6.80% levels, down 150bps from highs seen in May 2011 while the one year OIS is trading at 7.60% levels, down by 60bps from highs seen in June 2011.
Credit markets are also reflecting a softer period for interest rates with corporate bond yields down by 30bps from highs seen in June 2011. Five and ten year AAA corporate bond yields are trading at 9.4% levels, down from levels of 9.7% seen in June. Money market yields are also down with one year bank CD (Certificate of Deposit) yields down by 60bps from highs seen in June.
The fact that government bond yields have underperformed interest rates swaps and corporate bond yields suggest underlying concern on inflation, RBI policies and government finances. Inflation as measured by the WPI (Wholesale Price Index) is trending at 9.22% levels and is expected to remain at over 9% levels for the next three months. There is a consensus emerging in the market that the RBI is almost through with rate hikes, after having hiked the benchmark repo rate by 125bps in the last three months. However government bond yields are not reflecting that view. Government finances are a cause for concern and markets are factoring in an overshoot of the budgeted borrowing for the fiscal 2011-12. The government has consistently been running an overdraft balance with the RBI by around Rs 50,000 crores and it has yet to raise fuel prices to reduce the losses of oil marketing companies. The losses are projected at Rs 120,000 crores of which only one third is budgeted.
Government bond yields will at some point of time start trending down on the back of worries on the global economy. Indian government bond yields have a lot of catching up to do with interest rate swap yields as the ten year government bond and five year OIS spreads is at multiyear highs of 150bps. RBI may provide the necessary fillip needed for government bond yields to trend down if they adopt a more calming stance on inflation.
Government bond auction
The government auctioned Rs 11,000 crores of bonds last week. The bonds auctioned were the 8.07% 2017 bond for Rs 3000 crores, the 7.80% 2021 bond for Rs 5000 crores and the 8.28% 2027 bond for Rs 3000 crores. The cut offs came in at 8.33%, 8.30%, and 8.57% respectively. The government has completed the first half borrowing for fiscal 2011-12 and the next auctions will commence from October 2011.