Sliding UST yields and USD is a liquidity headache for RBI. Falling UST yields increase the spread with Gsec yields leading to more inflows into INR Bonds. Weakening USD increases the attraction of INR Bonds leading to more debt flows. Continued fall in UST yields and USD will lead to a self fulfilling cycle of more flows and more liquidity into the country.
RBI is already grappling with high system liquidity on the back of demonetization overhang, rising capital flows and government spending. How will the central bank manage the rising liquidity in the system? Fx reserves are at record high levels of USD 398 billion and rising fast on the back of RBI fx purchases. RBI will have to issue more MSS bonds to sterilize the fx induced liquidity. Government spending will be funded through issue of CMB’s while long term demonetization liquidity will have to be sterilized by floating the SDF (Special Deposit Facility).
The markets will stay on a search for yields mode as liquidity stays high and increases. All available spreads will be bought into leading to spread compression. Read on weekly reports on for spread movements.
10 year benchmark UST yields have fallen to levels of 2.05% as of 8th September 2017, which is the lowest level seen since November 2016. 10 year UST yields have fallen 50bps from highs seen during this year. Lack of clarity of inflation with CPI and Core PCE staying below Fed’s target has led to Fed rate hike expectations coming off. Hurricanes in the US and Geo Political issues with North Korea have also contributed to rise in buying of safe haven treasuries. Muted wage growth is one main factor in keeping down inflation expectations.
The USD index has lost 12% since December 2016 on the back of improvement in the Eurozone economy and on the back of falling inflation expectations in the US. USD has also seen losses against the Chinese Yuan and other emerging market currencies including the INR. Falling USD leads to money flowing into higher yielding assets, largely emerging market currencies where interest rates are higher than in the US.
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 4486 billion as of 8th September 2017. The surplus was Rs 4645 billion as of 1st September. MSS and CMB securities outstanding were Rs 1500 billion and this will increase as RBI sterilizes fx purchases liquidity.
Government bond yields rose last week on expectations of CPI inflation printing higher for August. The new benchmark 10 year bond, the 6.79% 2027 bond saw yields close up by 6bps week on week at levels of 6.54%. The on the run bonds, the 6.79% 2029 bond and the 6.68% 2031 bond saw yields close up by 3bps and 2bps respectively to close at 6.84% and 6.65%. The long bond, the 7.06% 2046 bond saw yields close up by 3bps at levels of 7.14%. Gsec yields will fall on rate cut expectations though yields could be pressured in the near term on lack of directional cues.
The OIS market saw 5 year OIS yields fall by 1bps week on week to close at levels of 6.16%. The one year OIS yield fell by 1bps to close at 6.12%. OIS yields will fall on rate cut expectations and on fall in US treasury yields.