RBI has bought Rs 400 billion of bonds through three OMO purchase auctions since the beginning of April 2016 and will now have to step up its purchases if it has to fulfill its stated aim of bringing down liquidity to neutral territory.
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) was in deficit of Rs 1190 billion as of 20th May. The deficit was Rs 1194 billion in the week previous to last. Government surplus was Rs 292 billion last week, down by Rs 20 billion week on week.
Liquidity is coming under stress on the back of worries of a Fed rate hike in June. Capital outflows could intensify if FIIs pull out money on risk aversion. June is also a month of advance tax outflows, which will place further stress on liquidity.
RBI’s forward sales and purchase maturity mismatch will also show up in the coming months. Given FCNR B deposits maturity in the months of September, October and November 2016, RBI will have to manage forward sales. Maturing forward sales contracts will suck out liquidity from the system and though RBI has purchase contracts to offset the sales contracts, the contracts do not mature at the same time.
RBI has to make up for a shortfall of over Rs 1000 billion in liquidity in the coming months. RBI will not be able to buy USD to infuse liquidity into the system as the INR is under pressure from Fed rate hike expectations, with the currency falling by over 1.5% over the last one month. RBI will have to conduct more OMO purchase auctions and increase the size of each auction from Rs 100 billion /Rs 150 billion to Rs 200 billion/Rs 250 billion. RBI buying more bonds through OMO will help lower bond yields that are stuck in a narrow range.
Government bond yields have been stuck in an extremely narrow range with the ten year benchmark bond, the 7.59% 2026 bond moving in a 6bps range between 7.42% to 7.48% since the beginning of April 2016. Bond markets are not finding clear reasons to drive down bond yields further at this point of time given that yields have dropped by 50bps from highs seen in February 2016.
The benchmark ten year bond, the 7.59% 2026 bond saw yields closing up by 3bps at 7.48% levels. The 8.27% 2020 bond saw yields rising by 3bps at 7.37% levels. The 7.88% 2030 bond saw yields rising by 2bps to close at 7.77% levels while the 8.13% 2045 bond saw yields closing up by 1bps at 7.86% levels. Government bond yields are likely to trend down on expectations of OMOs.
OIS market saw one year OIS yields rising by 2bps and five year OIS yields rising by 3bps week on week. One year OIS yield closed at 6.68% while five year OIS yield closed at 6.74%. OIS yields will stay ranged until liquidity conditions ease.
Benchmark AAA corporate bond yields closed up last week on the back of rise in government bond yields. Three year bond yields closed up by 6bps at 7.94% levels with spreads down by 6bps at 57bps levels. Five year bond yields closed up by 2bps at 8.08% with spreads down by 2bps at 57bps levels while ten year bond yields closed up 3bps at 8.23% with spreads flat at 61bps levels. Corporate bond yields will tend to follow government bond yields in the coming weeks.