Bond traders are not loudly cheering the strength in the INR and the record high levels in the Sensex and Nifty. The yield on the ten year benchmark government bond, the 8.83% 2023 bond grudgingly fell 4bps week on week to close at 8.81% levels. The INR strengthened by around 1.25% last week while the Sensex and Nifty rose by close to 4% each to close at record highs.
FIIs have bought USD 5.5 billion of INR bonds calendar year to date and in the first week of this month, they have bough USD 1.68 billion of INR bonds. FII bond purchases have largely been at the shorter end of the government bond and corporate bond yield curve and this has not really impacted yields at the longer end.
The market is also worried on cut offs in coming in higher levels due to an expected change in accounting rule (Read our weekly money published on 1st March 2014 on the SDL accounting issue). SDL auction for Rs 84.45 billion is scheduled for the 11th of March and higher cut offs in terms of yields in this auction could pull up government bond yields. This SDL auction should be the last but one of the auctions for this fiscal year 2013-14.
The INR rallied on the back of positive and equities, with net purchases in equities at USD 0.5 billion in the first week of this month. CAD (Current Account Deficit) for the October-December 2013 quarter was sharply down to USD 4.2 billion from USD 31.9 billion seen in the same period of the previous year. CAD is expected at below USD 40 billion for fiscal 2013-14, down 54% from last fiscal year levels of USD 87 billion.
Bond markets should ideally react positively to a stronger INR as the primary reason for government bond yields backing up by 165bps from levels of 7.16% on the ten year bond seen in May 2013. INR fell by over 20% to record lows of USD 68.80 in August 2013 on the back of worries of the Fed tapering its asset purchase program.
The US economy added 175,000 jobs in February 2014 against market expectations of 150,000 jobs. Unemployment rate rose to 6.7% in February from January levels of 6.6%. The Fed is likely to continue with its USD 10 billion asset purchase taper in its 18th-19th March policy meet, taking down asset purchases by USD 30 billion since December 2013. Markets are taking the Fed’s asset purchase reduction in its stride and are not carrying on with business as usual.
Bond traders should shrug off worries and look to go long at higher levels of yields, as the environment is looking positive given INR strength, falling CAD and FII flows.
Liquidity eased last week as banks demand for funds came off in the reporting week. Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI, MSF (Marginal Standing Facility) borrowing and term repo borrowing totaled Rs 1020 billion last week against a total of Rs 1200 billion seen in the week previous to last. Liquidity will get tighter as March progresses on advance tax outflows and fiscal year end demand for funds.
Five and ten year benchmark AAA corporate bond yields fell by 5bps and 3bps respectively week on week on the back of a rally in the INR. Five and ten year credit spreads were almost flat at 59bps to 70bps respectively. Corporate bond yields are likely to trend down in the second half of March on markets positioning for easing liquidity in April 2013.
OIS (Overnight Index Swaps) market saw the curve invert on the back of expectations of tight liquidity conditions. One year OIS yield rose 2bps while five year OIS yield fell 2bps to close at levels of 8.70% and 8.54% respectively and the five over one OIS spread inverted by 4bps to close at 16 bps levels. OIS yield curve is likely to shift down if INR shows sustained strength.