Inflation as measured by the WPI (Wholesale Price Index) for July 2012 came in better than expected at 6.87% against market expectations of around 7.25%. The fall in inflation actually helped take up bond yields rather than bring it down. Ten year benchmark bond yields rose by 6bps week on week to close the week at 8.23% levels. The market chose to look closer into the inflation numbers rather than take the fall in headline inflation at face value.
Headline inflation came off from 7.25% seen in June 2012 to 6.87% for the month July wholly due to a fall in fuel price index. The fuel price inflation fell from June levels of 10.27% to levels of 5.98% in July. The fuel price index fell 3.3% month on month to register the fall in inflation. The high base of fuel index last year due to a diesel price hike led to the fall in fuel price inflation.
The markets see fuel price fall as a temporary fall as diesel and LPG (Liquefied Petroleum Gas) prices are understated given that the government continues to subsidize them heavily. The losses of state run refiners such as IOC (Indian Oil Corporation), BPCL and HPCL in the first quarter 2012-13 bear testimony to the heavy subsidy of the diesel and LPG. IOC recorded the largest ever loss of over Rs 20,000 crores for the first quarter 2012-13 on the back of the government delaying subsidy payments.
The rise in oil prices over the last couple of weeks in the global markets has hurt sentiments on inflation. Brent crude oil prices have risen by over 13% over the last couple of weeks on worries of supply disruption due to middle east tensions, drop in US supplies and on the back of fresh risk asset trades by investors. Iran tensions continue on its nuclear program and US crude oil inventories dropped last week on higher demand for oil by US consumers. Expectations of bond purchases by the ECB is helping risk appetite leading to rise in prices of risk assets including oil.
Bond yields will not rise much higher from current levels of 8.23% as markets will look to buy at higher levels of yields. Rate cut hopes are alive in the markets given the deterioration in growth outlook with the government revising its GDP growth forecast from levels of 7.6% to levels of 6.7%.
Interest rate swap market saw yields rise on the back of rise in US treasury yields. Five year OIS (Overnight Index Swap) yields rose 16bps week on week while one year OIS yields rose 7bps. Five year OIS yields followed a 15bps rise in US ten year treasury yields last week. US treasury yields rose as investors shifted out of low yielding safe haven assets into risk assets. OIS yields should stabilize at current levels of 7.17% and 7.81% on the five and one year OIS respectively.
Corporate bond yields rose by around 2bps week on week on the back of rising government bond yields. Five and ten year benchmark AAA credit spreads closed last week lower by 3bps and 6bps respectively. Five and ten year credit spreads will hover around levels of 90bps each as government bond yields stabilize at higher levels and corporate bond yields stay sticky at current levels.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction tightened last week as banks over covered their product to account for a holiday shortened reporting week. Bids for repo averaged Rs 61,000 crores on a daily basis last week against an average of Rs 44,000 crores seen in the week before last. Liquidity is likely to be easier in the coming week given that banks will be well covered on their product in the reporting fortnight.
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 8.32%, 8.42%, 8.59% and 8.65% respectively. The government is scheduled to auction Rs 15,000 crores of bonds this week.