The INR closed at its highest level in over 18 months at Rs 64.40 to the USD last week. Strong portfolio flows on the back of economic and political stability in India and on the back of expectations of a gradual pace of rate hikes by the Fed and ECB and BOJ maintaining stimulus, drove the INR up against the USD. India’s fx reserves touched all time highs as RBI bought USD to cool INR’s sharp rise.
RBI buying USD to ease the pace of appreciation of the INR is adding liquidity into the system. Given that the system is flushed with liquidity due to demonetization, RBI fx purchases adding to liquidity will necessarily have to be sterilized.
RBI in its policy last week stated that it would lower system liquidity to bring it down to neutral levels at around 0.25% of NDTL. Liquidity added through fx purchases would lead to RBI using MSS Bonds and OMO sales to sterilize the liquidity.
RBI liquidity sterilization would lead to the short end of the yield curve trading at levels of 6.25% to 6.5% from current levels of below 6.25%. RBI will use long term reverse repos to suck out the liquidity from demonetization.
RBI liquidity measures would lead to markets taking comfort in spreads. Long end of the gsec yield curve where spreads are 100bps over repo and corporate bond spreads at over 100bps over repo would be favoured.
Bond markets will be comforted by a weaker than expected US jobs data that showed 98,000 jobs being added in March against expectations of 180,000 jobs. The Fed will keep its rate hike pace gradual in the face of weak jobs data.
The first government bond auction for fiscal 2017-18 went off well with bid to cover ratio of 3.42x. Bond yields fell post auction and this indicates that demand for government bonds is still high despite a hawkish RBI outlook on inflation.
The ten year benchmark bond, the 6.97% 2026 bond saw yields rise by 12bps week on week to close at levels of 6.81%. The bond yield touched a low of 6.60% intraweek before climbing by 21bps post RBI policy. The old ten year benchmark bond, the 7.59% 2026 bond saw yields rise by 20bps to close at 7.05% levels while the 7.88% 2030 bond saw yields rise by 10bps to close at 7.43%. The 8.13% 2045 bond saw yields rise by 13bps to close at 7.58%. Bond yields will await RBI liquidity moves before taking any directional position.
OIS market saw one year OIS yield and five year OIS yield rise by 5bps and 11bps respectively last week. One year OIS yield closed at 6.46% while five year OIS yield closed at 6.75%. OIS curve could flatten on RBI liquidity measures.
10 year benchmark AAA bond yields closed higher by 18bps at 7.78% levels with spreads up by 5bps at 85bps levels. Benchmark 3 year AAA corporate bond yields closed 12bps up week on week at 7.43% levels. Credit spreads fell by 5 bps to close at 59 bps levels. 5 year benchmark AAA bond yields closed up by 11bps at 7.58% with spreads down by 15bps at 59ps levels. Credit spreads will stay down as markets buy into spreads on the back of RBI liquidity measures.
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 4391 billion as of 7th April 2017. The surplus was Rs 3876 billion in the week previous to last.There were no MSS bonds outstanding. Liquidity came back into the system as banks released year end funds into the system. Liquidity will stay high on RBI fx purchases.