The government auctioned a new ten year benchmark bond in its bond auction last week. The cut off for the bond came in at 7.17% and post auction cut off, the bond yield fell to 7.09% levels. The yield on the new 10 year bond fell largely on the back of the RBI rejecting all bids for the long bonds in the auctions. RBI rejected all bids for the 7.73% 2034 bond and the 7.72% 2055 bond in the auction. The rejection may have been due to the fact that the market would have bid at higher levels of yields in the auction, leading to steepening of the yield curve.
The rejection of auction bids provides only a temporary relief to the market. The market is faced with supply issue with both the government and state governments issuing bonds on a weekly basis. Market is staring at a supply of over Rs 250 billion weekly over the next few weeks. In the backdrop of Union Budget 2018 and RBI policy in the first week of February, markets will bid nervously in auctions, leading to yields trending higher.
The 7.17% 2028 bond yield is likely to rise going into the budget on the 1st of February.
The advance GDP estimates for this fiscal year 2017-18 shows that the economy is expected to grow by 6.5% in real terms and 9.5% in nominal terms, which is lower than RBI revised forecast of 6.7% for real GDP growth and government’s forecast of 11.88% for nominal GDP growth. Lower than forecast for nominal GDP growth will take up the fiscal deficit as percentage of GDP as the fiscal deficit will be higher given that the government is borrowing an additional Rs 500 billion this year to meet revenue shortfall. Fiscal deficit was pegged at 3.2% of GDP for this fiscal year.
Government is also likely to miss its fiscal deficit target of 3% of GDP for next fiscal year given that it would look to spend more to shore up the economy, which has grown at the slowest pace in four years. Market will anticipate higher borrowings next year.
On the positive front, fx reserves touched record highs of USD 409 billion on the back of strong portfolio flows. Liquidity is high in the system at around Rs 2200 billion despite currency in circulation rising by over Rs 1000 billion in the September-December 2017 period. RBI fx purchases have led to rise in system liquidity.
The economy is still running an output gap that will keep down inflation pressures. The INR has appreciated by over 6% against the USD over the last one year and has shrugged off Fed rate hikes. The USD closed the year 2017 on a low note despite Fed rate hikes and strong economic data, which indicates the markets preference towards higher yielding currencies. US economy added 148,000 jobs in December, disappointing expectations for an increase of 185,000. The unemployment rate remained unchanged at 4.1%, as expected. The report also showed that U.S. average hourly earnings rose 0.3% last month, in line with projections.
In the near term, negatives outweigh positives for the 7.17% 2028 bond but once the market has priced in all the negatives, the bond yield will trend down from highs as positives take over.
The old 10 year benchmark government bond, the 6.79% 2027 bond, and saw yields fall by 4bps week on week to close at levels of 7.28%. The on the run bond, the 6.79% 2029 bond saw yields close 4bp up at 7.20% levels and the 6.68% 2031 bond saw yields close down by 7bps at 7.35%. The long bond, the 7.06% 2046 bond saw yields close down by 3bps at levels of 7.61%. Gsec yields would trend up on near term worries.
The OIS market saw 5 year OIS yields closing 6bps lower week on week at levels of 6.69%. The one year OIS yield closed down by 1bps at 6.43%. OIS yield curve will steepen on the back of Fed rate hikes and bond market worries.
Corporate bonds saw 5 year AAA corporate bond yields close down by 3bps at levels of 7.71% and 10 year AAA corporate bond yields close down by 8bps at 7.82%. 5 year AAA spreads fell by 6bps at 41bps and 10 year AAA spreads rose by 15bps at 60bps due to the lower yield cut off in the new 10 year benchmark bond. Corporate bond yields will be sticky on the back of high system liquidity and spreads will move on movements in government bond yields.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facility (MSF or Marginal Standing Facility) and MSS/CMB bond issuance was in surplus of Rs 2265 billion as of 5th January 2018. The surplus was Rs 761 billion as of 29th December. Government spending and RBI fx purchases added to the system liquidity.