RBI stated post policy last week that it will suck out excess liquidity arising from fx operations by issuing MSS bonds and carrying out OMO bond sale auctions. As of 8th December 2017, MSS bonds outstanding were Rs 1 trillion. RBI has bought a cumulative of USD 16.3 billion in the April-September 2017 period adding around Rs 1 trillion of liquidity into the system. RBI has also built a forward USD position of USD 31 billion, which is around Rs 2.2 trillion of latent liquidity.
RBI has been fighting a double whammy of liquidity, one from demonetization and the other from fx. Demonetization liquidity pain is more or less over as currency in circulation at levels of Rs 16. 36 trillion as of 1st December 2017 is around Rs 1.2 trillion less than peak levels of currency in circulation seen before Demonetization in November 2016. Currency in circulation had fallen to lows of Rs 9 trillion post demonetization. However fx pain remains and will increase as capital flows increase on higher growth prospects for India as compared to the rest of the EM countries.
RBI may have to issue bonds through MSS or sell bonds through OMO for over Rs 2 trillion to suck out fx induced liquidity. This could increase if capital flows rise sharply given the risk on nature of global financial markets at present. Equities are at record highs and credit spreads are down to pre 2008 levels indicating the high levels of liquidity in global markets.
The bond market has multiple worries of inflation ticking up with RBI raising its CPI inflation forecast from 4.2% to 4.6% to 4.3% to 4.7% for the second half of fiscal 2017-18. Prospects of higher borrowings this year with fiscal deficit at 96% of budget as of October 2017 is looming large. Budget for next year may see the government veering away from its stated fiscal deficit target of 3% of GDP.
Fed rate hike this month is an almost done deal on strong US economic data with the US adding 228,000 jobs in November, better than expectations. Unemployment rate was steady at 17 year low of 4.1%. Wage growth was muted.
Supply of bonds from RBI, government and states amidst negative inflation sentiment and strong global economic data will drive 10 year gsec yields higher going forward.
The 10 year benchmark government bond, the 6.79% 2027 bond, saw yields rise by 2bps week on week to close at levels of 7.08%. The on the run bond, the 6.79% 2029 bond saw yields close 1bp down at 7.12% levels and the 6.68% 2031 bond saw yields close up by 3 bps at 7.14%. The long bond, the 7.06% 2046 bond saw yields close down by 5bps at levels of 7.41%. Gsec yields would rise on multiple worries for the bond market.
The OIS market saw 5 year OIS yields closing 2bps lower week on week at levels of 6.56%. The one year OIS yield closed down by 2bps at 6.29%. 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 up by 3bps at levels of 7.53% and 10 year AAA corporate bond yields close up by 1bps at 7.75%. 5 year AAA spreads fell by 3bps at 48bps and 10 year AAA spreads fell by 2bps at 54bps. 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 2219 billion as of 8th December 2017. The surplus was Rs 1716 billion as of 2nd December.. Liquidity will stay comfortable on government spending and RBI fx purchases though advance tax payouts in December could lower the liquidity in the short term.