The bond market is finally seeing some light at the end of the long tunnel. The market has been hit by inflation, rate hikes, and tight liquidity and ever increasing supply of government bonds and these factors have kept the market on a bearish mode for the past three years. The intensity of the four factors mentioned here has decreased over the last six months and a couple of factors are actually turning positive for the markets. Bond yields will look to trend down from current levels of 8.20% on the ten year benchmark government bond on the back of positive sentiments in the market going forward.
Inflation as measured by the WPI (Wholesale Price Index) for the month of August 2012 came in at 7.55% against market expectations of around 6.95%. The higher than expected inflation number negated some of the euphoria of the diesel price hike effected by the government and the yield on the 8.15% 2022 government bond rose 6bps from lows post inflation data release. Inflation expectations are still around 7% to 7.5% over the next couple of months but the fact is that there are no fresh drivers of inflation. Inflation has been sticky at over 7% levels largely due to slow pass through of administered prices such as electricity and fuel to the end user.
In terms of demand and global commodity prices, inflation outlook is not negative. On the demand side, falling economic growth (GDP growth will be revised to below 6% levels from levels of 6.5% by the RBI) shows weakening demand in the economy. Global commodity prices are still down 5% over the year while oil prices are still down around 6% from highs seen last year.
RBI is not expected to cut rates in its 17th September 2012 policy review given the higher than expected inflation numbers. However if there are any surprises by the RBI it will be the surprise of rate cuts as the government has shown some signs of recognizing the need for fiscal consolidation by raising the politically sensitive prices of diesel. Diesel prices were hiked by Rs 5 per liter the first hike in the last one year.
Liquidity conditions have eased considerably over the last six months with deficit system liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI coming off by around Rs 60,000 crores. Repo bids are averaging around Rs 40,000 crores against an average of around Rs 100,000 crores seen six months back. RBI bond purchases of Rs 80,000 crores coupled with rising bank deposits and low credit growth (Incremental Credit Deposit Ratio stood at 25% as of 31st August 2012) is also helping ease liquidity conditions. Outlook for liquidity is more positive than negative going forward on the back of neutral policy, low demand for credit, rising deposit growth and positive portfolio flows (FII’s have invested over USD 13 billion in Indian bonds and equities calendar year 2012 to date).
Government borrowing was threatening to overshoot budgeted levels of Rs 479,000 crores for fiscal 2012-13. The hike in diesel prices coupled with restrictions on LPG subsidy will help consolidate government finances even though the absolute quantum of fuel subsidy will rise from budgeted levels of Rs 43,000 crores. The government may yet borrow more but that borrowing will only be know post January 2013. The government recognizes the need to keep its borrowing down as it forces RBI to go slow on rate cuts and forces interest rates higher in the economy. This recognition will have a positive effect on bond markets that were complaining about a complete lack of empathy to fiscal consolidation by the government.
Corporate bond market saw yields fall on the back of easing liquidity expectations. Five year and ten year AAA benchmark bond yields fell 8bps and 4bps respectively week on week. Five year and ten year AAA credit spreads fell 8bps and 2bps week on week on the back of fall in corporate bond yields. Outlook for AAA credits are positive on the back of easing liquidity conditions and stable to positive sentiments on government bond yields.
OIS (Overnight Index Swap) yields fell on the back of fuel price hikes with one and five year OIS yields falling by 4bps and 3bps week on week respectively. OIS yields are likely to hover around current levels though there will be a tendency for the market to start receiving the five year government bond and five year OIS spread, which is at 100bps at present. The spread is attractive given the turning sentiments on government bonds.