The 8% floor on overnight rates maintained by the RBI in its quest to lower inflation expectations has resulted in Flat Yield Curves. The longer the RBI delays in signaling a prospective cut in the Repo Rate, the flatter will be the yield curve. At some point of time, when the RBI does signal lower rates the whole yield curve will fall and steepen at the same time.
The government bond yield curve has flattened out completely. Three year, five year, ten year and thirty year bond yields are at levels of 8.30%, 8.39%, 8.37% and 8.54% levels respectively. The difference between the three year and thirty year government bond yield is just 24bps indicating that markets are not anticipating inflation expectations to rise. In fact the flatness indicates that the market is taking whatever extra yield that it gets and does not mind the interest rate risk in investing in long maturity bonds.
Given the flatness of the government bond yield curve and the floor of 8% funding rates, markets have moved to corporate bonds in search of yields. The corporate bond yield curve is extremely flat with three, five and ten year AAA corporate bond yields at levels of 8.80%, 8.93% and 8.97% respectively. Three, five and ten year credit spreads are at levels of 30bps, 37bps and 42bps respectively. Markets will continue to buy into higher yields offered by corporate bonds irrespective of the levels of credit spreads.
OIS yield curve is inverted with five year OIS yield at levels of 7.50% and one year OIS yield at 8.03%. OIS market is betting on RBI lowering interest rates going forward but given that the OIS yield curve has been inverted for the past three years, it may not be the best indicator of RBI rate actions. However one year OIS yield dropped by 19bps last week from levels of 8.22% to 8.03% and this sharp drop is on the back of rising expectations of an easing interest rate regime.
RBI’s Technical Advisory Committee (TAC) is urging the Governor Dr. Raghuram Rajan to consider lowering the Repo rate given that CPI inflation is down to levels of 6.46% as of September 2014 from levels of over 9.5% seen last year, global oil prices coming off by over 20% over the last few months and global growth increasingly looking downbeat giving various issues.
Dr. Rajan would prefer to wait and watch the developments on the domestic and global front before easing stance on interest rates and until then yield curves will stay flat. When the first signal of easing comes about, yield curves will fall and start to steepen as markets factor in easing Repo Rates going forward.
Liquidity tightened last week as banks demand for funds increased ahead of Diwali. System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and 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 965 billion last week from Rs 691 billion seen in the week previous to last. Government is running cash surplus of around Rs 1100 billion and if it starts to spend, liquidity will ease significantly.