Inflation risks that were playing in the minds of bond market participants are receding leading to bond yields coming off. The new benchmark 10 year bond, the 6.79% 2027 bond saw yields close down 3bps week on week at levels of 6.70%. The old 10 year benchmark bond, the 6.97% 2026 bond, saw yields close down by 6bps at 6.85% levels while the on the run bonds, the 6.79% 2029 bond and the 7.06% 2026 bond saw yields drop by 12bps and 10bps respectively to close at levels of 6.88% and 7.37%. The yield curve flattened and can flatten further as markets buy into spreads available in the longer bonds.
Two key inflation risks were being priced into bond yields, one was monsoons and the other was GST. Both the risks have receded with monsoons being forecast as normal and GST rates largely benign rather than inflationary. CPI inflation for April 2017 printed at a record low 2.99% against 3.89% seen in March. RBI has forecast that inflation will be benign in the first half of this fiscal year before starting to climb on the back of various factors that includes risks of monsoons and GST. RBI has also taken into account the inflationary impact of the rent allowance in the 7th Pay Commission and also upside risk to global crude oil prices. The rent allowance impact on inflation remains to be seen while crude oil prices have stabilized at around USD 50/bbl with forecasts down rather than up given the supply glut in the market.
One inflation factor that is still uncertain is the closing of the output gap. Increase in aggregate demand on economic expansions can lead to demand supply gap coming off, which can push up prices in the economy. Exports have grown by high double digit levels in March and April indicating that global demand is picking up.
OIS market saw one year yield fall by 2bps and five year OIS yield fall by 8bps last week. One year OIS yield closed at 6.47% while five year OIS yield closed at 6.64%. OIS curve spreads fell by 6bps. OIS yield curve does not have too much room to fall and is more likely to stay ranged.
10 year benchmark AAA bond yields closed lower by 8bps at 7.68% levels with spreads down by 6bps at 87bps levels. Benchmark 3 year AAA corporate bond yields closed lower by 2bps at 7.38% levels. Credit spreads were up by 2bps at 60 bps levels. 5 year benchmark AAA bond yields closed lower by 14bps at 7.44% with spreads down by 12bps at 48bps levels. Credit spreads are likely to trend down from higher levels as markets search for 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 Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) and MSS bond issuance was in surplus of Rs 4288 billion as of 19th May 2017. The surplus was Rs 4615 billion in the week previous to last. RBI is sucking out liquidity through issue of MSS securities and Cash Management Bills.