Dr. Raghuram Rajan, the RBI governor, will address his last monetary policy review on the 9th of August 2016. Dr. Rajan became RBI governor in August 2013 and will not stand for a second term once his term ends this month. In all probability, he will stand pat on rates this week, but given that the government passed the all important GST bill that will enable it to lower fiscal deficit in the coming years and given that the monsoons have been above average this year and will keep food inflation in check, there is an outside chance of a 50bps cut in the Repo Rate.
The fact that the RBI is now absorbing excess liquidity rather than infusing liquidity into the system provides a good reason for a rate cut. Instead of absorbing liquidity at 6.5%, which is the Repo Rate, absorbing liquidity at 6% post a 50bps rate cut will prompt banks to lend to the economy instead of parking surplus liquidity with the RBI. Banks, in the absence of a rate cut, will continue to buy government bonds rather than lend as government bond yields are dropping leading to treasury gains.
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 surplus of Rs 536 billion as of 5th of August. The surplus was Rs 256 billion in the week previous to last. Government surplus was zero last week. Liquidity will stay easy on government spending.
Government bond yields have fallen sharply since Brexit on 23rd June 2016. The yield curve has shifted down with a flattening bias. Ten year benchmark bond yields have dropped 35bps while the fifteen and thirty year bond yields have dropped by 53bps and 47bps respectively. Banks have reaped in treasury gains as bond yields are at over three year lows.
RBI will be paying a dividend of over Rs 600 billion to the government this month, which will come back into the system in the way of government spending. Liquidity will further ease in the system and the surplus could cross over Rs 1000 billion. However, FCNR B deposit maturity outflows could tighten liquidity over the next three months, though that will be nullified by inflows from RBI forward purchase contract maturity. Read our analysis on FCNR B outflows for a full understanding of RBI’s swap transactions.
RBI policy will be driven by a committee once Dr. Rajan steps down, and that committee will have to maintain an inflation target of 4% (with a +/- 2% range). Hence, the time to cut rates, if the RBI believes it is required, is in this month.
The government bond market saw bond yields closing mixed last week. The 8.27% 2020 bond yield rose 1bps to close at 7% levels while the 7.59% 2026 bond yield closed up 1bps at 7.17% levels. The 7.88% 2030 bond yield closed down 1bps at 7.25% levels while the 8.13% 2045 bond yield closed down 2bps at 7.36% levels. Government bond yields will fall further on rate cut expectations.
OIS market saw one year OIS yields close flat and five year OIS yields close up by 2bps week on week. One year OIS yield closed at 6.50% while five year OIS yield closed at 6.51%. OIS yields will stay soft on easy liquidity conditions and on rate cut expectations.
Benchmark AAA corporate bond yields closed mixed last week. Three year bond yields closed down by 5bps at 7.48% levels with spreads down by 7bps at 44bps levels. Five year bond yields closed up by 3bps at 7.61% with spreads up by 1bps at 42bps levels while ten year bond yields closed down by 6bps at 7.80% with spreads down by 7bps at 50bps levels. Corporate bond yields will fall on rate cut expectations.