Bond markets are going into New Year 2014 on a nervous note with yield curves shifting higher across segments. Markets are worried about rising US treasury yields, higher bond supply and tightening liquidity conditions. The ten year benchmark bond, the 8.83% 2023 bond saw yields move up by 16bps week on week to close at 8.96% levels, the highest levels since issuance of the bond in November 2013. One and five year OIS yields moved higher by 8bps and 7bps respectively while five and ten year AAA benchmark corporate bond yields moved higher by 10bps and 5bps respectively.
US ten year treasury yields closed last week at 3% levels, the highest level in two and half years. Domestic bond markets are worried about FII money moving out of emerging market bonds and into US treasury yield curve that is steep with ten over one spreads at 290bps. FIIs can borrow cheap at the short end and invest at the long end to earn the carry of 290bps. The fact that the Fed has pledged to keep rates at close to zero percent levels well into 2015 will keep the short end of the curve down.
The fear of bond markets of FIIs going into US treasuries while well founded is maybe overdone. FIIs have invested close to USD one billion in INR bonds in December 2013 and at limit utilization of below 30% are under weight INR bonds. The scope for more bond purchases given INR stability and high spreads of 600bps between ten year bonds is higher than normal.
The government is at the end of its 2013-14 fiscal year borrowing program with just 13% of borrowing to be completed by the first week of February 2014. Market is worried that the government may exceed budgeted borrowing given weak revenue growth. However the government has maintained that it would stick to its borrowing program and if it does keep to its word the market sentiment would improve.
Liquidity is tight in the system with the market borrowing over Rs 1000 billion from the RBI. Overnight money market rates are trading at MSF (Marginal Standing Facility) rate of 8.75% as high cash balances of the government estimated at over Rs 500 billion is forcing the market to borrow from the MSF window apart from repo and term repo windows. Liquidity is likely to ease in January on government spending and inflows through interest payments on Special Deposit Scheme.
Bond market sentiments are likely to improve in January 2014 as the fears that are driving yields higher become unfounded.