Government bonds continued the post Brexit rally last week with yields falling by 1bps to 7bps across the curve. Ten year benchmark government bond yields are trading at three year lows and the outlook is still positive for bonds. Record low levels of global bond yields, anticipation of rate cuts by the RBI in August, hopes of GST bill being passed in Parliament this session and good system liquidity are the factors that are contributing to the bond rally. However as in any sharp asset class rally, it is always good to watch out for factors that could stall or derail the rally. What are the factors that could stall the bond market rally?
On the global front, risk aversion coming back to the fore is a key factor in stalling the bond market rally. Global risk aversion fell sharply post Brexit as equities, bonds and commodities rallied on expectations of central banks prolonging ultra accommodative monetary policies. However given that global economic outlook is still weak and Brexit may weaken the outlook further, rallies in risk assets could derail and that could lead to fresh outflows from emerging markets. Global currency markets are still on tenterhooks post Brexit, with the British Pound falling to three year lows, the Yen strengthening and the Euro weakening against the USD. China too devalued the Yuan to protect its exports. A sharp move towards the safe haven USD could lead to weakness in emerging market currencies, leading to capital outflows. The INR could weaken on risk aversion leading to rise in bond yields as rate cut hopes fall.
On the domestic front, inflation is trending at close to two year highs on the back of rise in food prices. Global commodity prices too have risen from lows with oil prices up almost 100% from lows seen during the year. Inflation could stay sticky at higher levels if food prices continue to stay high and oil prices stabilize at higher levels.
Government finances that were in high surplus of around Rs 1500 billion at the beginning of the fiscal year have dropped to zero as of July. The government could even be drawing down on WMA (Ways and Means Advances) from the RBI to meet its expenditure. Government running tight cash levels could come to the market to borrow more than budgeted, which could lead to more than anticipated supply for the market leading to rise in bond yields. Non passage of GST bill in this parliament session could also affect bond yields negatively as it could cloud the fiscal deficit numbers of the government in the coming years.
At this point of time, none of the negatives for bond yields listed above look to be coming to the fore but it is always good to watch out for these factors.
The government bond market saw bond yields falling last week on rate cut expectations. The 8.27% 2020 bond yield fell 1bps to close at 7.04% levels while the 7.59% 2026 bond yield closed down 2bps at 7.25% levels. The 7.88% 2030 bond yield closed down 7bps at 7.39% levels while the 8.13% 2045 bond yield closed down 6bps at 7.54% levels. Government bond yields will fall further on rate cut expectations.
OIS market saw one year OIS yields close up by 3bps and five year OIS yields close up by 3bps week on week. One year OIS yield closed at 6.50% while five year OIS yield closed at 6.56%. OIS yield curve rose on the back of rise in global bond yields as equity rally led to fall in demand for safe haven bonds. OIS yields will stay soft on easy liquidity conditions and on rate cut expectations.
Benchmark AAA corporate bond yields closed down last week. Three year bond yields closed down by 2bps at 7.61% levels with spreads down by 4bps at 55bps levels. Five year bond yields closed down by 13bps at 7.68% with spreads down by 13bps at 44bps levels while ten year bond yields closed down by 6bps at 7.95% with spreads down by 4bps at 57bps levels. Corporate bond yields will fall on rate cut expectations.
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 27 billion as of 8th July. The surplus was Rs 26 billion in the week previous to last. Government surplus was zero last week. Liquidity will stay easy on government spending and RBI USD purchases.