The environment for the bond market is distinctly turning positive and this should reflect in lower government bond yields going forward. Government bond yields fell 4bps to 8bps week on week across the curve with the benchmark ten year bond, the 8.40% 2024 bond seeing yields fall by 4bps to close last week at 8.46% levels. The “On the Run” bonds, the 8.27% 2020 bond and the 8.60% 2028 bond saw yields fall by 8bps and 7bps respectively to close at levels of 8.51% and 8.59%. Bond yields have fallen by around 20bps over the last forty days on the back of the market environment turning bond yield friendly.
Government finances are in good shape with cash surplus of over Rs 1000 billion post advance tax receipts on the 15th of September. The government cut its borrowing size by Rs 160 billion in the first half of fiscal 2014-15 on the back of its healthy cash position and also bought back Rs 127 billion of bonds to provide liquidity to the system. Government borrowing for the April-September period is Rs 3520 billion with the last auction of Rs 120 billion scheduled for the 26th of September 2014.
The total borrowing including buybacks for the full fiscal year is budgeted at Rs 6000 billion and the government is likely to borrow Rs 2480 billion in the second half of fiscal 2014-15. However, of the Rs 2480 billion borrowing for the second half, Rs 500 billion may not come into the market if the government does one on one bond switches with insurance companies and provident funds. Bonds worth Rs 500 billion would be redeemed in the October–November period and net market borrowing would only be around Rs 1480 billion.
Government finances are being helped by falling oil prices with Brent crude falling to two year lows on the back of excess global supply as the US is importing less oil. Oil Marketing Companies are now selling diesel at a profit and that will lower the fuel subsidy bill of the government. Fertilizer subsidy too will fall on lower oil prices. Fuel and fertilizer subsidy is budgeted at Rs 1360 billion for this fiscal.
Inflation expectations are trending down on the back of falling commodity prices, government containing fiscal deficit and RBI maintaining a vigilance on inflation. Global commodity prices have hardly moved over the last one year and are down almost 50% from peaks seen in 2008.
Government is keeping to fiscal deficit target of 4.1% of GDP for this fiscal against 4.5% of GDP seen in the last fiscal while RBI is maintaining repo rates at 8% to meet its CPI target of 6% in January 2016. CPI inflation was at 7.8% in August 2014, down from 7.96% seen in July and from 9.52% seen last year. Core CPI that is CPI stripped of food and fuel prices, slipped to 7% in August 2014 from 7.5% levels in July and over 8% levels seen last year.
On the global front, the Fed is expected to start raising its policy rate from July 2015 while the ECB has cut rates to record lows and will be undertaking a USD 700 billion asset purchase program. The Fed will stop asset purchases in October 2014. Low rates and easy liquidity is positive for FII flows into INR Bonds. FIIs have invested USD 13.6 billion in INR Bonds since April 2014.
OIS market saw the yield curve inverting week on week. One year OIS yield fell 3bps while five year OIS yield fell 14bps to close at levels of 8.43% and 7.88% respectively. The Five over One OIS spread inverted by 11bps to close at negative 55bps levels. The curve should start flattening from these levels as liquidity is expected to ease going into October 2014.