The bond market is having its first “Happy Diwali” in almost six years given that sentiments have been bearish on yields since beginning of 2009. Diwali 2013 was particularly bad for bond market as RBI took up interest rates to arrest a sharply depreciating INR. The benchmark ten year bond is going into Diwali, which is on the 23rd of October, on a positive note with yields at 8.39%, down by almost 30bps on a year on year basis.
More importantly, the outlook for bond yields has turned distinctly positive given that CPI and WPI inflation have trended down sharply since last year. CPI has fallen from levels of 9.84% seen in September 2013 to 6.46% in September 2014 while core CPI has come off from levels of over 8% to levels of below 6%. WPI has come off from 7.05% to 2.38% while core WPI is at one year lows of 2.80%. Inflation expectations are cooling off given that global crude oil prices are down by close to 25% over the last few months on the back of oversupply and falling demand due to global economic weakness.
The government too is playing its role in improving bond market sentiments. Government borrowing is cut by Rs 80 billion from budgeted levels and cash position of the government is healthy at around Rs 1100 billion. The appointment of Arivind Subramanian as the Chief Economic Advisor is seen as positive by the markets given his credibility in the field of economics and markets expect him to focus on lowering inflation expectations, which will align the government with the RBI. RBI policy is tilted towards inflation targeting with forecast for CPI at 6% by January 2016.
Liquidity has turned structurally positive for being structurally negative and this is having a positive effect on bond market sentiments. 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 705 billion last week from Rs 152 billion seen in the week previous to last. Liquidity tightened on the back of RBI OMO sales of around Rs 80 billion, rising government surplus and festive season demand for funds. Government is running cash surplus of around Rs 1100 billion and if it starts to spend, liquidity will ease significantly.
The sharp fall in ten year US treasury yields that has fallen by close to 90bps since December 2013 is adding to the positive bond market sentiment. US treasuries are factoring in slower pace of rate hikes by the Fed going forward given global issues.
Government bond yields fell week on week as markets bought into expectations of falling long term interest rates. The ten year benchmark bond, the 8.40% 2024 bond saw yields fall by 6bps to close at 8.39% levels. The five year bond, the 7.28% 2019 bond saw yields fall by 10bps to close at 8.39% levels while the longer bonds, the 8.60% 2028 bond and 9.23% 2043 bond saw yields fall by 5bps and 8bps to close at levels of 8.53% and 8.58% respectively. Bond yields will look to trend down given positive sentiments in the market.
OIS market saw the yield curve falling week on week on the back of falling ten year US treasury yields. One year OIS yield fell 14bps while five year OIS yield fell 16bps to close at levels of 8.22% and 7.54% respectively. The Five over One OIS spread inverted by 2bps to close at negative 68bps levels. OIS yields will continue to trend down on expectations of lower interest rates going forward.