The system is facing a glut of liquidity and it is creating problems for the bond market. Liquidity that was in high surplus due to demonetization has been rising despite money going out of the system through currency in circulation, which has risen by Rs 800 billion in the first three weeks of this month. Liquidity is rising due to RBI fx intervention due to the strengthening INR that touched 20 months highs last week and government spending. RBI has stated that it will use all available tools to bring system liquidity to neutral at +/- 0.25% of NDTL and it has commenced sale of Tbills under MSS and Cash Management Bills to suck out liquidity.
The bond market is facing a problem with the excess liquidity. The market is unsure of the government bond yield curve as excess liquidity increases supply of bonds as RBI sucks out liquidity and also causes expectations of inflationary pressures. The short end of the curve is hit by bond supply while the medium and longer end of the curve is hit by rising inflation expectations.
Bond market is choosing to trade ranges and parking excess funds in term reverse repos and treasury bills and CMB’s. The 15 day CMB auction for Rs 200 billion held last week drew in bids for over 12x the auction size indicating the demand for the short dated instrument.
Government bond yields rose last week on market’s worry over excess liquidity. The ten year benchmark bond, the 6.97% 2026 bond saw yields rise by 5bps week on week to close at levels of 6.96%. The old ten year benchmark bond, the 7.59% 2026 bond saw yields rise by 3bps to close at 7.03% levels while the 7.88% 2030 bond saw yields rise by 5bps to close at 7.38%. The 8.13% 2045 bond saw yields rise by 8bps to close at 7.59%. 10 year bond yields will trade in a tight range around current levels on market’s uncertainty on liquidity and inflation.
OIS market saw one year yield rise by 4bps and five year OIS yield rise by 9bps last week. One year OIS yield closed at 6.52% while five year OIS yield closed at 6.82%. OIS curve will trend higher on lack of triggers for a yield curve fall.
10 year benchmark AAA bond yields closed higher by 8bps at 7.76% levels with spreads up by 3bps at 68bps levels. Benchmark 3 year AAA corporate bond yields closed higher by 7bps at 7.40% levels. Credit spreads were flat at 51 bps levels. 5 year benchmark AAA bond yields closed higher by 7bps to close at 7.53% with spreads up by 5bps at 50ps levels. Credit spreads could rise on RBI MSS and CMB auctions but will then fall again 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 4267 billion as of 28th April 2017. The surplus was Rs 4059 billion in the week previous to last. Liquidity is being neutralized by MSS and CMB auctions.