The 10 year benchmark bond, the 6.79% 2027 bond, saw yields close at over one year high levels at 7.06% last week. The yield was up 6bps week on week. The bond market is in a pessimistic mode on the back of worries of government finances and on expectations of RBI staying status quo on rates. Fiscal deficit touched 96% of full year budgeted levels as of October 2017, which could mean higher borrowings this fiscal year if revenues are not higher than expenditure in the next few months.
RBI is widely expected to maintain status quo on policy rates in its MPC (Monetary Policy Committee) meeting on 5th and 6th of December. Policy stance will be kept neutral even as CPI inflation range of 4.2% to 4.6% for the second half of this fiscal year stay’s unchanged and GDP growth forecast of 6.7% stay’s unchanged. Negative surprise in the form of change in stance from neutral to tight or rate hikes is highly unlikely.
RBI will also stop OMO bond sales to suck out system liquidity as liquidity has come off substantially from levels of over Rs 4 trillion to levels of below Rs 2 trillion. RBI had sold bonds worth Rs 900 billion in this fiscal year as of November 2017.
Given that any negative surprise is highly unlikely, the bond market is unlikely to react to the policy statement. However, the market might pick positive cues to cover shorts and this could lead to a rally in yields post policy. Positive cues could be in the form of maintaining rates at current levels of 6% for an extended period of time, stopping OMO bond sales, keeping calm on inflation expectations and managing liquidity through LAF (Liquidity Adjustment Facility) and MSS bonds for fx liquidity sterilization.
The highest positive surprise would be a rate cut, which could send yields tumbling down in the short term. Real rates of over 2% will be the reason for rate cut but as the RBI avoided rate cuts when real rates were over 3%, it is highly unlikely to cut rates in this policy. GDP growth of 6.3% for the 2nd half of the fiscal year against 5.7% for the first quarter will provide comfort for the RBI that high real rates are not hampering economic growth.
The 10 year benchmark government bond, the 6.79% 2027 bond, saw yields rise by 6bps week on week to close at levels of 7.06%. The on the run bond, the 6.79% 2029 bond saw yields close 5bps up at 7.13% levels and the 6.68% 2031 bond saw yields close up by 5 bps at 7.11%. The long bond, the 7.06% 2046 bond saw yields close up by 5bps at levels of 7.46%. Gsec yields could drop on any positive comments by RBI in its policy this week.
The OIS market saw 5 year OIS yields closing 5bps higher week on week at levels of 6.58%. The one year OIS yield closed up by 2bps at 6.31%. OIS yield curve will steepen on the back of Fed rate hikes and RBI policy status quo.
Corporate bonds saw 5 year AAA corporate bond yields close up by 4bps at levels of 7.50% and 10 year AAA corporate bond yields close up by 1bps at 7.74%. 5 year AAA spreads rose by 2bps at 49bps and 10 year AAA spreads fell by 5bps at 56bps. Corporate bond yields will be sticky post policy 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 1716 billion as of 1st December 2017. The surplus was Rs 1116 billion as of 24th November. Government repurchase of bonds for Rs 277 billion added liquidity into the system. 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.