US economic data is pointing to the Fed stopping asset purchases by end of calendar year 2014 and commence raising rates from record low levels in 2015. The US treasury yield curve, which is steep at present, is expected to start flattening out going forward. Short end rates will rise from close to zero percent levels while medium to long end rates will stay steady or rise marginally.
Markets will start positing for US treasury yield curve flattening. Short end rates being close to zero percent will give an almost risk free, no negative carry short positions while long end yields provide good carry given low cost of funding at present. US 3 months, 1 year and 2 years treasury yields are at levels of 0.02%, 0.10% and 0.42% respectively while five, ten and thirty year yields are at levels of 1.66%, 2.58% and 3.37% respectively. The US treasury yield curve is a classical steep yield curve that is factoring in higher short end rates going forward on the back of higher economic growth.
The US April 2014 job numbers were highly positive with 288,000 jobs being added for the month and unemployment rate dropping to five and half years low at 6.3%. Market reaction to the hugely positive job numbers, the highest monthly addition since January 2012, were muted with ten year treasury yields falling by 4bps, the USD index staying almost flat and US equities falling. The market reaction was muted as the positive job number was accompanied by a decline in average hourly earnings and weakest labor participation rate since 1978.
US GDP growth for the first quarter of 2014 was at 0.1% the weakest growth level since 2009. Bad weather is blamed for the poor performance and the number did not prompt the Fed from continuing its asset purchase taper in its April meet. The Fed cut asset purchases by USD 10 billion bringing down the monthly asset purchases to USD 45 billion. The Fed has indicated that it will stay on course on its tapering and is now looking at when to start raising interest rates.
A flattening US treasury yield curve may not have much repercussion on India even as funding costs rise. The high spreads between US and Indian ten year bond yields at levels of 620bps would take care of the flattening out of the US treasury yield curve.
Government bond yields moved down between 4bps to 9bps week on week, as the market was comfortable in absorbing high weekly auction supply. Ten year benchmark bond the 8.83% 2023 bond saw yields closing down by 7bps at levels of 8.81%. Government bonds are unlikely to react negatively to the US job numbers given that ten year US treasury yields closed down post the data release.
Corporate bond yields fell by 6bps to 9bps across the curve. Five and ten year AAA credit spreads fell marginally by 1bps and 2bps respectively to close at levels of 47bps and 48bps. Corporate bond yields will be bid given that the market is buying into higher absolute levels of yields.
OIS market saw the five year OIS yield falling by 10bps week on week to close at 8.35% levels. One year OIS yield fell 2bps to close at 8.60% levels. The curve inverted with the five over one OIS spread inverting by 8bps to close at 25bps levels. OIS markets are factoring in no potential rate hikes by the RBI given weak economic growth.
Liquidity tightened last week as banks demand for funds increased in the second week of the reporting fortnight. Banks borrowing from the RBI was at Rs 985 billion last week from Rs 800 billion seen in the week previous to last. Liquidity has tightened on the back of government bond auctions taking out liquidity from the system and not coming back in the form of government spending.