The OIS market saw 5 year OIS yields falling by 14bps week on week to close at levels of 6.12%. The one year OIS yield fell by 7bps to close at 6.13%. The inversion of the 1*5 OIS curve suggests that the market is playing for a 25bps rate cut in October.
RBI maintained a neutral stance while lowering rates by 25bps in its policy review last week. However, markets believe that structural inflation is falling on weak aggregate demand as seen by the lack of new investment projects, which the RBI highlighted in its policy review statement. Core inflation at 4% levels provides the RBI enough headroom to cut rates by 25bps as even after the cut, real rates will be 1.75% at repo rate of 5.75%. RBI believes that the real rates should be around 1.25% for the economy. RBI last cut rates in October 2016 citing real rates at 1.25%.
Markets will also take comfort from the fact that 10 year US treasury yields closed at levels of 2.26% broadly unchanged despite a strong July jobs report. US economy added 209,000 jobs in July against expectations of 183,000 jobs. Unemployment rate fell to 4.3% from 4.4% last month. Fed is on course to hike rates by 25bps one more time this year but lack of strong wage gains suggest that inflation is not looking to tick up.
10 year Gsec yields will follow the 5 year OIS yield in its downward path. The new benchmark 10 year bond, the 6.79% 2027 bond saw yields close down by 2bps week on week at levels of 6.44%. The old 10 year benchmark bond, the 6.97% 2026 bond, saw yields close down by 3bps at 6.64% levels while the on the run bond, the 6.79% 2029 bond saw yields close down by 3bps to close at 6.73%. The long bond, the 7.06% 2046 bond saw yields close down by 6bps at levels of 7.02%. Gsec yields will fall on rate cut expectations.
Corporate bond yields closed down last week. 10 year benchmark AAA bond yields closed lower by 3bps at 7.30% levels with spreads down by 1bps at 76bps levels against the new 10 year benchmark gsec, the 6.79% 2027 gsec. 3 year AAA spreads were higher by 5bps at 55bps and 5 year spreads were higher by 8bps at 51bps. Benchmark 3 year AAA corporate bond yields closed down by 5bps at 6.98% levels. 5 year benchmark AAA bond yields closed flat at 7.08%. Credit spreads are likely to come off on liquidity and rate cuts.
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 5112 billion as of 4th August 2017. The surplus was Rs 4319 billion in the week previous to last. Liquidity will stay easy on government spending and RBI fx purchases.