The government bond market failed to embrace positive talk on policy rate cuts by the RBI. The ten year benchmark government bond the 8.15% 2022 bond yield closed last week at 8.16% levels almost unchanged week on week. The yield curve flattened in the ten over thirty segment with the spread coming off by 7bps to close the week at 26bps levels. The spread came off on the back of a 6bps fall in yield on the benchmark thirty year bond the 8.83% 2041 bond. The 8.83% 2041 bond yield closed at levels of 8.42% last week against levels of 8.48% seen in the week previous to last. The flattening of the ten over thirty spreads was due to the lower issuance of government bonds at the long end of the curve. (DNA Money 1st October 2012).
The flat close on the ten year benchmark government bond yield despite rate cut talks suggest that markets need either more conviction for yields to fall or need more time to get used to an expected easing policy environment. The market is lacking in conviction on interest rates trending down on the back of worries of government finances and inflation. The government did maintain its budgeted borrowing program for the second half of fiscal 2012-13 but that has not convinced the market that it will not borrow more going forward. The diesel price hike done in September 2012 will only partly bring down the subsidy bill of the government and oil marketing companies continue to make losses despite price hikes.
Tax collections are not seen very much higher as the economy is projected to grow at below forecast levels of 6.7% (revised forecast from budget forecast of 7.6%). Growth projections of various other agencies and economists are in the 5.5% to 6% range. The market will require more on the ground data to firm up on its belief that the government can maintain its borrowing schedule for 2012-13.
Inflation is not going to give much respite in the next two months. The diesel price hike will impact inflation numbers for September 2012 while expected hikes in power tariffs by state governments to fulfill loan recast obligations will push up inflation in the coming months. Inflation as measured by the WPI (Wholesale Price Index) printed at 7.55% for August 2012 and forecasts are not much lower from August numbers.
The market will not go short into the October 30th RBI policy review and this will help keep bond yields stable to even positive in the coming week. Traders will use any rise in yields to buy and any fall in yields to sell and this activity will keep bond yields in an 8.10% to 8.20% range, unless there is a sudden change in rate cut expectations.
Markets could well start expecting a 50bps rate cut in the policy review this month given downward forecasts of growth and a government that is showing some form of commitment to fiscal consolidation. A higher than forecast rate cut expectation will gain ground closer to the policy date of 30th October and bond yields will then trend down to well below 8.10% levels.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI eased last week on the back of government spending and release of end September funds by the banks. Bids for repo averaged Rs 36,000 crores on a daily basis against an average of Rs 72,000 crores seen in the week previous to last. Liquidity will remain in an Rs 30,000 crores to Rs 40,000 crores deficit in the coming weeks.
Corporate bond market saw one year CD (Certificate of Deposit) yields fall sharply week on week. One year CD yields fell 40bps week on week on the back expectations of easy liquidity conditions. Five and ten year AAA corporate bond yields fell by 5bps and 8bps respectively as mutual funds bought into the market on the back of good flows into income funds. Corporate bond and CD yields are likely to stabilize at current levels as markets wait for more news on policy expectations.
OIS (Overnight Index Swap) market saw five year OIS yield fall by 5bps week on week while one year OIS yield stayed flat. The five over one spread inverted by 5bps on the back of the fall in five year OIS yield. One year OIS yield should start falling as the policy date approaches.
Government bond auctions
The government auctioned Rs 13,000 crores of bonds last week. The bonds auctioned were the 8.19% 2020 bond for Rs 3000 crores, the 8.20% 2025 bond for Rs 7000 crores, and the 8.83% 2041 bond for Rs 3000 crores. The cut offs came in at 8.20%, 8.21%, and 8.42% respectively. The government is scheduled to auction Rs 13,000 crores of bonds this week.