The monsoons have been 22% below normal as of third week of July 2012 and the weak monsoons are raising the prospect of higher food prices. Higher food prices take up the overall inflation levels leading to worries on whether RBI has the scope to cut interest rates in its policy reviews. Food articles have a 14.34% weight in the overall WPI (Wholesale Price Index) and rising food prices has a strong impact on the WPI.
Inflation as measured by the WPI came in at 7.25% for the month of June 2012 against levels of 7.55% seen in May despite higher food price inflation. Food prices rose 10.81% in June against a rise of 10.74% seen in May. The lower than expected inflation (market was expecting June inflation at 7.6%) brought down bond yields by around 3bps to 7bps across the curve week on week. The market will pause at levels of 8.07% on the benchmark ten year bond, the 8.15% 2022 bond as the 31st July policy review date is just over a week away. Bond market will speculate on the impact of weak monsoons on RBI policy decision and will not take aggressive rate cut positions going into the policy.
The ongoing drought in US has taken corn and soya prices to record highs. The sentiment of rising food prices in US coupled with weak domestic monsoon will have adverse impact on food prices in India. Rising food prices on the back of weakening economy will take down economic growth further and if the economy faces headwinds on interest rates, the end effect can be bad.
RBI has to take a tough decision of holding on to policy rates looking at rising food prices or cutting policy rates to prevent an escalation of downside growth expectations. The central bank in the current context of threat to the economy from various sources including weak domestic monsoons, Eurozone debt issues, US “Fiscal Cliff” and China hard landing is more likely to view rising food prices as a threat to the overall economy and cut rates. Central banks across the world have gone in for rate cuts in the face of worsening economic growth sentiments and RBI will follow their cues in reducing domestic interest rates.
Corporate bond yields fell by around 10bps week on week as the market bought into higher spreads. Five and ten year AAA benchmark corporate bond spreads at 116bps and 103bps levels respectively offer reasonable yield pick up over the corresponding maturity government bonds. Credit spreads are unlikely to come off sharply as long as liquidity remains in deficit or is in marginally positive territory. Liquidity has to ease considerably to highly positive levels for credit spreads to come off.
The OIS (Overnight Index Swap) markets saw the five over one spread invert by 4bps week on week and the spread closed at negative 70bps. Five year OIS yields fell 2bps and one year OIS yields rose 2bps week on week to close at levels of 6.95% and 7.65% levels respectively. The five year OIS yield is factoring in rate cuts, which if it does come about will bring down one year OIS yields sharply. There is contradiction in the inverted spread curve in the OIS market and the spread should correct post RBI July policy review
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI tightened by around Rs 13,600 crores last week. Banks covering their product in the first week of the reporting fortnight led to higher demand for funds. Liquidity is likely to be in deficit of around Rs 40,000 crores to Rs 50,000 crores this week.
Government bond auctions
The government auctioned Rs 15,000 crores of bonds last week. The bonds auctioned were the 8.19% 2020 for Rs 4000 crores, the 8.33% 2026 bond for Rs 7000 crores, the 8.28% 2032 bond for Rs 2000 crores and the 8.33% 2041 bond for Rs 2000 crores. The cut offs came in at 8.13%, 8.20%, 8.46% and 8.57% respectively. The government is scheduled to auction Rs 15,000 crores of bonds this week.