The bond market has to cross many hurdles before it can establish a firm footing. The market is plagued by multiple worries starting with rate hikes by the RBI, Fed taper, and bond switch by the government and higher borrowings. The benchmark ten year bond, the 8.83% 2023 bond saw yields close up 5 bps week on week as players lightened positions on uncertainty.
The market is expecting RBI to hike the repo rate by 25bps in its mid term policy review on the 18th of December 2013. The record high levels of CPI (Consumer Price Index) that rose 11.24% year on year in November 2013 is prompting markets to factor in a rate hike despite the IIP (Index of Industrial Production) showing zero percent growth in the first seven months of this fiscal.
A repo rate hike of 25bps will largely be seen as positive by the markets as it will also be looked at as the last of the rate hikes. RBI would like to guide the economy through the election period that ends in May 2014 and given that growth is looking extremely weak and inflation is largely driven by vegetable prices that have risen by 61% year on year, the central bank could keep rates on hold.
Fed tapering or no tapering would be announced post RBI policy review. Fed is expected to announce tapering starting January 2014 or give an indication of the month of commencing the taper on the back of the US economy showing signs of recovery. Unemployment rate at 7% in November 2013 is at five year lows and is trending towards Fed’s comfort zone of 6.5%. Fed taper will be seen as positive by markets as it removes uncertainty and it indicates the growing confidence of the Fed in the US economy.
On a technical issue, the government could go ahead with a bond switch of Rs 500 billion that it had budgeted for this fiscal. The government would buy back illiquid securities from the market and issue new securities. The market does not welcome the exercise that is cash neutral as it does not want to face fresh supply of bonds.
The government has just a few months to go into the elections and the calls for extra spending on a flagging economy are growing. The FM has indicated that the government would not exceed deficit and borrowing targets but markets always worry about politics driving economics.
The positives for the market at present are the sharp fall in current account deficit (CAD) and the improved liquidity conditions. The CAD is expected to come off by 30% in this fiscal and that would add stability to the Indian Rupee even if Fed announces tapering of asset purchases. Liquidity has become comfortable with the RBI adding over Rs 2000 billion from FCNR B swaps. The market is not going to the MSF (Marginal Standing Facility) window for funds and overnight rates are ranging in the reverse repo to repo band of 6.75% to 7.75%.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) auction of the RBI, bids for MSF (Marginal Standing Facility) and bids for term repo was a negative Rs 620 billion as of 13th December 2013. RBI has provided additional Rs 100 billion through term repos to the market to tide over 15th December advance tax payment outflows.
Credit spreads as measured by difference between government bond yields and AAA corporate bond yields rose week on week on the back of corporate bond yields rising to reflect higher government bond yields. Benchmark five and ten year AAA credit spreads closed last week at 80 bps and 60bps levels up 3bps and 18bps each respectively. Credit spreads are likely to move more on the back of movements in government bond yields.
OIS (Overnight Index Swaps) market saw the yield curve move up week on week with one and five year OIS yields rising by 8bps and 15bps respectively. The curve inversion came off by 7bps on expectations of rate hikes with the five over one spread closing at levels of negative 2bps. The curve could steepen if RBI indicates a hold on rate hikes going forward.