Rate cut expectations are completely out of the bond market and if at all there is any surprise in RBI 3rd and 4th October policy review, it will be a rate cut. Status quo on policy rates will keep bond yields largely unchanged at current levels while a rate cut would pull down yields by 15bps to 20bps.
RBI is going into this policy review with many factors to consider, both for and against a rate cut. The “For” factors include weakening economic outlook with 1st quarter GDP growth at levels of 5.7% against full year forecasts of over 7%. Lack of investment demand, banking sector NPA woes, demonetization after effects and GST implementation have contributed to the weak growth in the 1st quarter and expectations of lower than forecast growth in the coming quarters. Banking system liquidity is also high with over Rs 2.5 trillion of liquidity and with RBI continuing to absorb liquidity through reverse repos, the liquidity is not filtering into higher lending by banks with credit growth at 6.85% as of 15th September.
FII flows have been strong in INR bonds largely due to rate differentials and an appreciating INR. RBI has USD 26 billion of forward purchases outstanding as it has been postponing the liquidity impact of its intervention. FII’s have almost exhausted their corporate bond limit and space for government bonds too is low. FII flows have been largely unhedged as seen by the violent fall in the INR from Rs 64 levels to Rs 66 levels in just under two weeks on the back of risk aversion due to geo political tensions on North Korea and due to Fed rate hike expectations and balance sheet unwinding.
RBI will have to weigh the effects of unhedged flows causing excessive currency volatility and lowering rate differentials through rate cuts can help keep the flows steady rather than excessive.
On the “Status Quo” side, RBI will consider Fed guidance of rate hikes and balance sheet unwinding, global financial market volatility, higher oil prices on supply disruption issues and domestic CPI inflation that has trended higher over the last couple of months. Government considering a fiscal push could also play a factor if it is seen as inflation negative.
Government bond yields closed mixed last week. The benchmark 10 year bond, the 6.79% 2027 bond saw yields close flat week on week at levels of 6.66%. The on the run bond, the 6.79% 2029 bond saw yields close 2bps down at 6.93% levels and the 6.68% 2031 bond saw yields close up by 2bps at 6.86%. The long bond, the 7.06% 2046 bond saw yields close up by 6bps at levels of 7.21%. Gsec yields will stay ranged if RBI maintains rates Status Quo.
The OIS market saw 5 year OIS yields closing 1bps lower week on week at levels of 6.27%. The one year OIS yield closed down by 5bps at 6.10%. OIS yields will stay ranged on policy unless there is a rate cut.
Corporate bonds saw 5 and 10 year AAA corporate bond yields falling by 2bps and 3bps respectively. Credit spreads fell by 7bps and 9bps respectively. RBI has increased FII limits for corporate bonds by Rs 440 billion by taking out masala bonds from the total limits and FII’s should buy into higher spreads once markets stabilize.
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 Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) and MSS bond issuance was in surplus of Rs 2587 billion as of 29th September 2017. The surplus was Rs 2395 billion as of 22nd September. Liquidity should rise as banks end of half year demand for funds falls.