Bond markets had a positive start to calendar year 2014 with bond yields falling by 9bps to 13bps across the curve. The ten year benchmark government bond the 8.83% 2023 bond closed last week at levels of 8.83%, down 13bps week on week. Five and ten year AAA benchmark corporate bond yields closed down by 4bps and 7bps respectively at levels of 9.66% and 9.63%. One and five year OIS yields closed down by 8bps and 5bps respectively at levels of 8.43% and 8.41%. Bond yields closed down on the back of fresh position taking by markets at higher levels of yields.
The question going forward is will yields trend down on a sustained basis or will markets trade a narrow range given uncertainties ahead on elections, borrowing and budget? The outlook for bond yields look more positive than negative and yields are likely to trend down as the market gains confidence on positive factors. The positive factors for markets include an expected sharp fall in CPI (Consumer Price Index) inflation, easing liquidity conditions, stable INR and falling global crude oil prices.
The CPI inflation is expected to print at below 10% levels for the month of December 2014 against record high levels of 11.24% seen in November 2013. Vegetable prices have fallen sharply since October 2013 and this will benefit the CPI that rose on the back of over 60% rise in vegetable prices. RBI refrained from hiking the repo rate in its December 2013 policy review and may hold back rate hikes given falling inflation expectations.
Liquidity conditions are turning easier on the back of banks being flush with FCNR B funds that saw addition of Rs 210 billion into the system. Quarter end pressures tightened liquidity in December with the market accessing the MSF (Marginal Standing Facility) window for funds but with the start of a new quarter, the market has cut its borrowing from the MSF window leading to overnight rates falling by 100bps from 8.75% levels to 7.75% levels.
The INR saw some selling pressure in the beginning of the new calendar year and closed down by around 0.5% against the USD last week. However the outlook for the INR is positive given that the CAD (Current Account Deficit) is expected to drop by over 40% for fiscal 2013-14 and pressure on FII bond sales has reduced significantly. FII’s have sold USD 8 billion of INR bonds in calendar year 2013 and with limit utilization at less that 25% levels, FIIs will be buyers rather than sellers of bonds going forward.
Oil prices fell close to 5% last week on the back of US December 2013 oil imports falling to levels seen in 1998. US is producing more and more oil thanks to a shale oil revolution and this is lowering need for imported oil. Lower oil imports by the US would lead to oil prices falling sharply in global markets.
On the negative side, bond markets would watch out for any indications of higher than budgeted borrowing by the government. The government’s fiscal gap in the April-November 2013 period is 94% of full year estimated deficit and this is causing a worry for markets. The budget, which will be a vote on account given elections in April- May 2014, will also deter the market from taking heavy directional bets on yields.
The government is confident of keeping its deficit on track and if it does so then it is positive for bond yields.