Government bond yields fell sharply last week in anticipation of the government announcing a new RBI governor to replace Dr. Raghuram Rajan, who is not taking up a second term. Bond markets are hopeful that the new Governor will cut the Repo Rate in the RBI policy review in August. The market hope is based on the fact that the government will select a Governor who is more pliable on rates to encourage economic growth for the country.
The new Governor lowering rates might suit the bond market in the short term as bond yields fall but in the longer term, the market may not be as enthusiastic as it is now. Bond markets are extremely fickle and are usually deeply suspicious of government interference in monetary policy. The government’s agenda is growth at whatever cost as that ensures more votes. The belief may be questioned but no government wants to take a chance on improving macro economic fundamentals, which may prove unpopular in the short term but will definitely help the economy and its citizens over the longer term.
The bond markets, while welcoming rate cuts from the RBI, may start to steepen the yield curve in anticipation of rising inflation expectations brought about by accommodative policy. After a certain point of time, Rate Cuts will lose relevance if bond markets believe that it would lead to higher inflation down the line.
Given the fickle nature of bond markets, it is important for the government that the new Governor is given independence to take monetary decisions that will suit the economy in the longer term. The fact that the monetary policy will be run by a committee with the RBI committing itself to keeping inflation at 4% (+/- 2%) is positive and on no account this inflation target should be sacrificed for growth.
The government bond market saw bond yields falling sharply last week on rate cut expectations. The 8.27% 2020 bond yield fell 10bps to close at 7.05% levels while the 7.59% 2026 bond yield closed down 12bps at 7.27% levels. The 7.88% 2030 bond yield closed down 12bps at 7.46% levels while the 8.13% 2045 bond closed down 6bps at 7.60% levels. Government bond yields will fall further on rate cut expectations.
OIS market saw one year OIS yields close down by 4bps and five year OIS yields close down by 3bps week on week. One year OIS yield closed at 6.47% while five year OIS yield closed at 6.53%. OIS yield curve will fall on rate cut expectations.
Benchmark AAA corporate bond yields closed down last week. Three year bond yields closed down by 18bps at 7.63% levels with spreads down by 6bps at 59bps levels. Five year bond yields closed down by 10bps at 7.81% with spreads up by 1bps at 57bps levels while ten year bond yields closed down by 10bps at 8.01% with spreads up by 3bps at 61bps 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 26 billion as of 8th July. The deficit was Rs 89 billion in the week previous to last. Government surplus was zero last week. Liquidity eased as RBI bought USD to keep the INR from appreciating too fast on the back of strong capital flows.