The ten year benchmark government bond yield has fallen by around 80bps in calendar year 2014 from levels of 8.80% seen at the beginning of the year to levels of around 8% at the end of the year. Will the yield on the ten year gsec continue to fall in 2015?
The conditions for fall in yields on the ten year gsec are positive. Inflation as measured by the CPI (Consumer Price Index) is trending at below 5% levels and if global commodity prices stay weak, inflation is likely to end 2015 at RBI target levels of around 6% or below. Global commodity prices as measured by the Reuters CRB commodity index that tracks a basket of 19 commodities have fallen 16% in 2014. Crude oil prices are down 45% and outlook is extremely weak given rising supply and lack of demand.
Domestic demand drivers are not looking inflationary with the economy forecast to grow at levels of 5.5% in this fiscal year and by around 6.4% in the next fiscal year. Growth is down from levels of over 8% seen in the 2009-2011 period. The government is keen on lowering fiscal deficit to levels of 3% of GDP in 2016-17 from this year’s level of 4.1% of GDP and that is positive for lowering inflation expectations.
Global liquidity is expected to be abundant even if the Fed hikes interest rates. ECB and BOJ will keep pumping in liquidity in the system and the Euro and Yen will be funding currencies for carry trades that will see global investors continue to buy into higher yielding INR Bonds. FIIs have invested USD 20 billion in INR bonds in this fiscal year.
RBI is likely to cut the Repo Rate starting 2015 and will signal continuity in its accommodative policy stance. The repo rate was last raised by 25bps in January 2014.
Liquidity is structurally positive with RBI adding Rs 1100 billion through USD purchases this year. Government surplus and RBI OMO sales have kept system liquidity in deficit mode but given strong portfolio flows of around USD 29 billion this year as of 19th December and CAD (Current Account Deficit) expected at around USD 40 billion, the BOP (Balance of Payment) position will be positive leading to rising fx reserves as RBI buys USD.
The outlook for the ten year gsec looks positive and the bond yield is likely to trend down in 2015. The risk of the bond yield rising from current levels of 8% will arise if the Fed aggressively starts raising rates on the back of rising inflation expectations in the US. Indian government finances could also derail the downward momentum of the ten year gsec yield if weak economic growth hampers tax collection leading to higher government borrowing.
OIS (Overnight Index Swaps) market saw the curve falling week on week with one year OIS yields falling by 3bps and five year OIS yields falling by 7bps to close at levels of 7.87% and 7.29% respectively. OIS yields are likely to trend down given rate cut expectations starting 2015.
System liquidity tightened last week on third quarter end demand for funds. 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 1316 billion from Rs 1212 billion seen in the week previous to last. Liquidity is likely to ease on government spending in the first week of January 2015.