Bond market is confused by RBI actions on auctions, bond sales and liquidity. The 5th August policy review of the RBI gains significance as the market will want answers to why the central bank is acting in the way it is acting now. The market is not expecting any rate cuts despite CPI (Consumer Price Index) inflation trending below RBI target levels of 8% for March 2015. CPI printed at 7.31% for June with core CPI coming in at 7.4%.
RBI had factored in base effect on CPI and will not react to the June numbers. However the policy tone is expected to be more dovish than hawkish given both falling inflation and government’s commitment to keeping fiscal deficit in check. Budget 2014 in July saw the FM, Arun Jaitley sticking to deficit target of 4.1% of GDP as put forth by the previous government in February 2014 interim budget.
RBI surprised the market last week by holding a back to back auction of the newly issued ten year bond, the 8.40% 2024 bond. The auction size for the bond was increased from Rs 70 billion to Rs 90 billion. The market reacted negatively to the auction and traders who had positions built in the first auction at 8.40% levels sold the bonds in order to create space to bid for the bonds in the second auction. The yield on the 8.40% 2024 bond rose 14bps week on week on the back of RBI surprise move to close at levels of 8.52%.
RBI could have wanted a higher floating stock for the 8.40% 2024 bond for the IRF (Interest Rate Futures) market to trade the new contract based on the new bond. The central bank may also have wanted to provide FIIs a benchmark bond to fill up the newly released government bond limit of USD 5 billion.
Even more surprising for the market was the devolvement of two auction bonds on to the Primary Dealers (PDs). RBI devolved Rs 4.8 billion of the 8.27% 2020 bond (16% of auction amount of Rs 3000 billion) and Rs 29.6 billion of the 8.40% 2024 bond (32% of auction size of Rs 9000) billion on to the PDs at cut off levels of 8.55% and 8.52% respectively. The devolvement signals that the RBI did not want to give in to negative bids by the market.
The auction process was changed from uniform price, where all successful bidders get the bonds at the cut off price to multiple price where successful bidders get the bonds at the price they have bid. The market would have bid negatively in the auction in order to get the bonds at lower price than higher price.
RBI has been selling bonds through the NDS OM (Negotiated Dealing System) screen and has sold around Rs 60 billion in the months of June and July 2014. The market is wondering why RBI is selling bonds, whether it is a liquidity measure to offset USD purchases of over USD 7 billion in April and May 2014 or whether it is to cool down bond yields that had fallen by 50bps since April.
On the liquidity front, the market had to content with sudden tightness in liquidity over the last couple of weeks that has seen deficit rise from levels of Rs 700 billion to Rs 1300 billion. RBI has been slow to conduct extra term repo auctions to take care of the higher deficit and this has resulted in overnight money market moving up over 9% levels, up from 8% levels seen two weeks ago. RBI added Rs 900 billion through term repos last week in the face of higher system liquidity deficit and this cooled down money market rates. The reason for the sudden tightness in liquidity is not known and it could either be rising government cash surplus or RBI letting outstanding forward USD sales that have come up for maturity expire.
Ten year AAA credit spreads fell by 9bps week on week to close at levels of 58bps on the back of sharp rise in yields on the ten year government bond. Five year AAA spreads were flat at 67bps levels as bond yields rose in tandem with benchmark yields. Credit spreads would come off as the market searches for higher yields going forward.
OIS market saw one year OIS yields falling by 4bps and five year OIS yields staying flat to close at levels of 8.37% and 7.90% respectively. The five over one OIS spread flattened by 4bps to close at negative 47bps levels. The OIS curve is likely to trend down on expectations of lower rates and higher liquidity going forward.
Liquidity eased marginally last week as bank borrowing from RBI in repo and term repo auctions came off by Rs 30 billion week on week. Bank borrowing from RBI was Rs 102 billion last week. Liquidity is likely to ease going forward on government spending.