The RBI is expected to cut the benchmark policy rate the repo rate by 25bps in its mid term policy review on the 19th of March. Bond markets are starting to factor in the 25bps repo rate cut in bond yields. The benchmark ten year government bond the 8.15% 2022 bond saw yields drop by 6bps week on week on the back of rate cut expectations. Government bond yields are likely to drop further as the bond market positions for an expected cut in repo rates.
The RBI is going into the policy review on the back of third quarter 2012-13 GDP growth printing at 4.5%, well below RBI’s full year estimates of 5.5% and below first and second quarter growth of 5.5% and 5.3% respectively. The sharp drop in GDP growth coupled with the government lowering its 2013-14 fiscal deficit target to 4.8% from 5.2% seen in fiscal 2012-13 will prompt RBI to lower the repo rate.
Markets will watch the IIP (Index of Industrial Production) growth number for January 2013 and the inflation number for February 2013 that are to be released this week for signs of growth or inflation picking up. IIP growth is expected to print at over 1% for January 2013 against a negative growth of 0.6% seen in December 2013. Inflation as measured by the WPI (Wholesale Price Index) for February 2013 is expected to come in at around 6.6% levels, largely unchanged from January 2013. IIP and WPI printing at around market expectations will not have any negative impact on rate cut expectations.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI eased by Rs 55,000 crores week on week with bids for repo averaging Rs 58,000 crores on a daily basis last week against an average of Rs 113,000 crores seen in the week before last. Liquidity eased on the back of government spending and on the back of lower demand for funds by the banking system. Banks were overfunded on their product in the reporting fortnight leading to lower demand for overnight liquidity. Liquidity is expected to tighten on advance tax outflows expected in mid March.
Corporate bond yields fell week on week with five and ten year benchmark AAA corporate bonds seeing yields fall by 5bps each respectively. Five and ten year AAA credit spreads rose by 2bps each to close at 86bps and 89bps levels respectively. Credit spreads are likely to trend marginally higher on the back of tight liquidity conditions in March.
OIS (Overnight Index Swaps) yield curve flattened by 8bps week on week on the back of rate cut expectations. One year OIS yields fell 6bps while five year OIS yields rose 2bps to close at 7.57% and 7.24% levels respectively. The five over one OIS spread flattened to a negative 33bps last week from levels of a negative 41bps seen in the week previous to last. One year OIS yields are likely to fall further on expectations of a repo rate cut.