A falling INR raises fear of inflation and liquidity. The belief is that inflation trends up due to the higher cost of imports especially oil imports and as Indian has been facing high inflation of over 9% over the last two years, the threat of more inflation is negative on sentiments. Liquidity is impacted on a weakening INR due to fears of FII’s pulling out of Indian assets. A widening trade gap on costlier imports is another factor for liquidity drying up in the economy. Rising inflation and tightening system liquidity is negative for interest rates. Bond yields factor in rising interest rates when the INR weakens.
However, the sharp fall in the Indian Rupee (INR) to all time lows of over Rs 56 to the USD has actually helped the bond market. RBI has been buying bonds in the secondary market and through OMOs (Open Market Operations) to infuse liquidity into the system to negate the liquidity effect of USD sales. RBI selling USD in the market to prevent an uneven fall in the INR, takes out liquidity from the system.
The INR has fallen by over 8% fiscal year to date while ten year benchmark bond yields have dropped by 20bps from highs seen in the beginning of April 2012. Bond yields fell from highs on the back of two factors 1) RBI rate cut of 50bps in its April policy and 2) RBI buying of government bonds in the market. RBI has bought around Rs 50,000 crores of bonds including the bonds purchased in the OMO auction on the 25th of May. RBI bond purchases have helped the market absorb the heavy government borrowing of Rs 127,000 crores fiscal year to date. Hence bond yields have come off despite the negative effects of a weak INR.
Liquidity as measured by the bids for repo/reverse repo tightened marginally last week. Bids for repo averaged Rs 100,000 crores on a daily basis last week against an average of Rs 94,000 crores seen in the week previous to last. Liquidity tightened on the back of fresh product covering by banks in the beginning of the reporting fortnight. Liquidity is likely to ease this week on the back of RBI infusion of funds into the system through bond purchases and on the back of lower demand for funds in the reporting week
Money market rates moved up with one year CD (Certificate of Deposit) rates moving up by 15bps week on week. Increased demand for funds by banks to meet redemptions led to the rise in yields of CDs. June is expected to be a month of tight liquidity due to advance tax outflows and CD yields will reflect the tightness. However, it is unlikely that one year CD yields will trend up significantly higher than current levels of around 9.90%-10%, as RBI has been infusing liquidity into the system through bond purchases and through the LAF. One year CD yields will trend down in the second half of June as liquidity effects of RBI bond purchases and government spending impact yields positively
OIS (Overnight Index Swaps) curve moved up last week as the markets took off any bets of a June rate cut by the RBI. One year OIS yields moved higher by 4bps while five year OIS yields moved higher by 8bps and the five over one OIS curve lost its inversion by 4bps to close at a negative 52bps levels. OIS yields are likely to stay in a current range until RBI’s policy review in mid June.
Government bond auctions and OMO’s
The government auctioned Rs 15,000 crores of bonds last week. The bonds auctioned were the 8.24% 20218 bond for Rs 4000 crores, the 8.79% 2021 bond for Rs 6000 crores, the 8.28% 2027 bond for Rs 2000 crores and the 8.33% 2036 bond for Rs 3000 crores. The cut offs came in at 8.47%, 8.52%, 8.78% and 8.90% respectively.
The government is auctioning Rs 15,000 crores of bonds this week.
RBI bought Rs 11,193 crores of bonds this week through OMO’s. The bonds purchased were the 8.19% 2020 bond for Rs 4384 crores, the 9.15% 2024 bond for Rs 4979 crores, the 8.26% 2027 bond for Rs 27 crores and the 8.97% 2030 bond for Rs 1803 crores. The cut offs came in at 8.40%, 8.53%, 8.74% and 8.76% respectively.