The date 18th December 2013 has attained high significance for bond markets. The RBI will release its mid quarter monetary policy review statement and the Fed will release the outcome of its two day FOMC (Federal Open Market Committee) meet. The two events are of high significance to the bond markets as they can determine the future direction of bond yields.
Bond markets should react positively to a 25bps rate hike by the RBI as they would believe that this would be the last of the hikes given that INR is strengthening and food prices trending down post good monsoons would bring down inflation going forward. Fed tapering should be positive for markets given that the US economy is doing well with inflation under control and lowering excess money in the system would keep down inflation expectations.
The ten year benchmark bond, the 8.83% 2023 bond saw yields close up 12bps week on week on the back of markets nervousness on Fed tapering and RBI policy. The whole government bond yield curve shifted higher by 9bps to 15bps week on week as the markets lightened positions amidst thin volumes. Volumes in the government bond market dropped 50% as players stayed out to take fresh positions post 18th December.
RBI is expected to raise the repo rate by 25bps on the 18th of December, the third consecutive rate hike since September 2013. Repo rate will rise to 8% on a 25bps rate hike. RBI is likely to raise the repo rate in order to negate the USD 34 billion of primary liquidity it has added into the system through its FCNR B swap window that closed on the 30th of November 2013. System liquidity has become comfortable and overnight rates are moving in the reverse repo to repo band of 6.75% to 7.75%. Given that inflation at the wholesale and consumer levels are trending at six month highs, the central bank will be cautious on keeping liquidity cheap for the market.
Bond market is also ruling out more OMO (Open Market Operations) bond purchase auctions by the RBI given easing liquidity conditions. The government has Rs 1000 billion of auctions to go through before its borrowing gets over for this fiscal. Markets are also apprehensive of the government overshooting its borrowing program given weak tax revenues that are growing well below budgeted targets.
The positive November job numbers from the US has increased chances of the Fed commencing bond tapering in its 17th and 18th December policy meet. The US economy added 203,000 jobs in November 2013 against consensus estimates of 180,000 jobs. Unemployment rate fell to five year low of 7% in November, a rate that is closer to the Fed target levels of 6.5%.
Markets are apprehensive of Fed tapering as the first round of fears on tapering drove the INR down to record lows against the USD, which in turn led to liquidity tightening measures by the RBI. However given that the Euro strengthened against the USD and the Yen fell against the USD and equities rose post the jobs data, the INR is unlikely to see sharp negative reaction. Falling current account deficit that fell over 70% quarter on quarter in the second quarter of fiscal 2013-14 also helps the INR.
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 400 billion as of 6th December 2013. Liquidity has eased on account of strong inflows of USD 34 billion through the FCNR B swap window. Liquidity is likely to stay comfortable going forward given less pressure on the INR.
Credit spreads as measured by difference between government bond yields and AAA corporate bond yields fell sharply week on week on the back of corporate bond yields falling and government bond yields rising. Benchmark five and ten year AAA credit spreads closed last week at 61 bps and 42bps levels down 20bps each respectively. Five year credit spreads could trend down further as market buy into the shorter end of the spread curve.
OIS (Overnight Index Swaps) market saw the yield curve move up week on week with one and five year OIS yields rising by 3bps and 6bps respectively. OIS yields are likely to stay ranged from current levels given expectations of 25bps rate hike by the RBI in its December 2013 policy review.