The diesel price decontrol by the government has the bond markets tussling between rising inflation and lower fiscal deficit. The markets will question whether rising inflation will impact bond yields negatively or lower fiscal deficit will impact bond yields positively. In the short term the impact of higher fuel prices is negative for inflation but in the long term a lower fiscal deficit and correct pass through of fuel prices to the consumer will impact inflation positively.
The government decontrolled diesel prices and allowed oil companies to raise prices to cover their under recoveries. Oil companies immediately raised diesel price for bulk users by Rs 9.25/ litre and for retail consumer by Rs 0.45/litre. Retail prices of diesel is expected to go up every month as oil companies look to cover all their under recoveries in the next twelve months.
Bond yields that were trending down last week gave up some gains on the back of profit taking that was induced by an innocuous speech by the RBI governor where he mentioned that inflation in India was still high. However bond yields closed last week at two year lows, with the ten year benchmark bond the 8.15% 2022 bond closing at levels of 7.85%, on the back of bullishness on rate cuts and government finances. (Read). The bond market is expecting the RBI to cut repo rates by at least 25bps in its policy review on the 29th of January 2013.
The diesel price decontrol is highly positive for government finances. Government finances were looking bleak on the back of lower tax revenue growth with April-December net direct tax collection growing at around 8.4% against a fiscal year growth target of 15%. The government’s fuel subsidy bill was overshooting full year estimates of Rs 44,000 crores by 100% as higher global oil prices increased under recoveries of oil companies. The government is now in a much better financial condition as subsidies will come off on the back of fuel price hikes.
Global oil prices are unlikely to trend much higher from current levels of USD 110/bbl on Brent Crude as the US, which the world’s largest consumer of oil is expected to reduce oil imports by 20% over the next couple of years. US is increasing production of oil on the back of a shale oil revolution in the country. Stable oil prices coupled with full pass through of oil prices to the end user will help the government sharply reduce its subsidy bill in 2013-14.
A lower fiscal deficit projected by the government in 2013-14 will help bond markets as government borrowing could be stable or reduced. The RBI will also have more comfort in easing monetary policy as a manageable government borrowing will not force it to resort to bond purchases to provide liquidity to the system. RBI has bought over Rs 100,000 crores of bonds through OMO (Open Market Operations) purchase auctions fiscal year to date in order to pump in liquidity into the system. Bond purchases by the central bank are inflationary in nature and lower bond purchase helps the cause for controlling inflation expectations.
Liquidity was stable last week. Liquidity as measured by bids of repo in the LAF (Liquidity Adjustment Facility) auction of the RBI saw bids average at Rs 88,000 crores on a daily basis last week against an average of Rs 85,600 crores seen in the week before last. Liquidity is likely to stay flat in the coming weeks as there are no major inflows or outflows expected in the system.
Corporate bond yields closed flat week on week. Five and ten year benchmark AAA bond yields closed at levels of 8.70% and 8.72% respectively. Corporate bond yields are likely to stay positive on rate cut expectations.
OIS (Overnight Index Swaps) markets saw five year OIS yields trending down by 5bps while one year OIS yields rose 2bps week on week. The five over one OIS spread increased its inversion by 7bps and closed at a negative 41bps spread. OIS yield curve should start flattening out as RBI cuts rates and liquidity outlook improves.
Government bond auction
The government auctioned Rs 12,000 crores of bonds last week. The bonds auctioned were the 8.07% 2017 bond for Rs 3000 crores, the 8.33% 2026 bond for Rs 6000 crores and the 8.97% 2030 bond for Rs 3000 crores. The cut offs came in at 7.82%, 7.91% and 8% respectively. There is no government bond auction scheduled for this week while state governments are auctioning Rs 9900 crores of state development loans.