Crude oil prices have fallen sharply to two year lows on the back of a supply glut with US oil imports falling and global economies from the Eurozone to China facing growth issues. Brent crude is trading at USD 92/bbl and Nymex Crude is trading at USD 89/bbl, down 20% and 16% respectively since June 2014.
Falling crude oil prices is positive and negative for the bond market. On the positive side, lower oil prices will keep down fuel prices in the economy leading to fuel price inflation coming off. Transportation costs will also stay stable leading to general prices of goods and services staying stable. The government has achieved full pass through of petrol and diesel prices to end users and can now deregulate diesel prices leading to higher oil efficiencies in the economy. RBI will be able to judge true inflation in the economy for its policy setting and not worry about inflation effect of administered prices directly through suppressed inflation and indirectly through higher government fiscal deficit.
On the negative side, falling oil prices reflect weakening of global economic growth and risk aversion amongst global investors. Weak global economic growth could hit India’s exports leading to rising current account deficit (CAD). Global risk aversion could lead to capital flows out of the country, falling INR and rising bond yields.
The government’s tax revenues too would be impacted as weak global growth filters into India’s growth prospects. Fiscal deficit could rise leading to higher borrowing and with capital outflows, liquidity would be hit in the banking system and that would lower demand for government bonds. Bond yields would then rise.
At this juncture, falling oil prices would impact the bond market positively. Lower oil prices will help the RBI in achieving its CPI (Consumer Price Inflation) target of 8% and 6% in January 2015 and January 2016 respectively. RBI maintained Repo Rate at 8% in its 30th September 2014 policy review and signaled its intention to keep rates stable until inflation expectations come off. Bond markets could expect Rate Cuts next year if oil prices stay down.
The government has curbed subsidies by hiking diesel prices and with oil prices down, the subsidy bill would come off and lead to the fiscal deficit target of 4.1% of GDP being achieved even if tax collections come off on the back of weaker than expected economic growth. CAD at 1.7% of GDP for the first quarter of this fiscal year is down from 4.7% of GDP seen last year. RBI is confident of CAD being maintained at lower levels given falling oil prices. The INR would not come under too much of pressure as India’s macros are improving.
FIIs may not pull out from Indian equities and bonds given that global liquidity is high with ECB commencing asset purchase this month and policy rates are still at all time lows.
India’s credit rating has been upgraded from BBB negative to BBB stable on the back of the government’s commitment to lower fiscal deficit and bring about sustainable growth. The upgrade will lend stability to the INR.
Government bond yields rose week on week as RBI signaled a prolonged pause to rates. The ten year benchmark bond, the 8.40% 2024 bond saw yields rise by 4bps to close at 8.48% levels. The ten year bond yield will look to trend down as market reacts positively to falling oil prices.
OIS market saw the yield curve rising week on week on RBI rate signal. One year OIS yield rose 5bps while five year OIS yield rose 8bps to close at levels of 8.45% and 7.88% respectively. The Five over One OIS spread flattened by 3bps to close at negative 57bps levels. The curve should start flattening from these levels as liquidity is expected to ease this month.
Liquidity eased last week on government spending. 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 225 billion last week from Rs 526 billion seen in the week previous to last. System is well funded and liquidity is unlikely to tighten significantly in October despite festive season demand for funds.