The bond market is going into Diwali 2013 on a pessimistic note. The ten year benchmark bond, the 7.16% 2023 bond saw yields closing at 8.66%, up by 8bps week on week. Bond yields are rising on worries over many factors that are likely to affect the market in the month of November. The factors include the closing of the USD/INR swap window for OMCs (Oil Marketing Companies), closing of the FCNR B swap window (slated for 30th of November), liquidity conditions in the system and direction of food inflation.
Bond markets chose to ignore the cheer of equity markets to the RBI policy that saw the Sensex closing at record highs on the 1st of November 2013. RBI raised the benchmark policy rate, the repo rate in its 29th October 2013 policy review in order to bring down inflation expectations. Inflation as measured by the WPI (Wholesale Price Index) and CPI (Consumer Price Index) have averaged 8.5% and 9.5% over the last three and five years respectively and the central banks is extremely uncomfortable with the trajectory of inflation in the economy. However the RBI lowered the MSF (Marginal Standing Facility) rate by 25bps from 9% to 8.75% to normalize the repo-MSF spread to 100bps. The central bank increased the term repo facility for banks to 1% of NDTL (Net Demand and Time Liabilities) from 0.5% of NDTL but refrained from removing restrictions on banks access to LAF (Liquidity Adjustment Facility) that is at 0.5% of NDTL.
The RBI governor Dr. Raghuram Rajan in post policy interaction with media and analysts highlighted lingering concerns on inflation and value of the INR. The bond market took these concerns as signs of the RBI hiking the repo rate by 25bps in its December 2013 policy review. The market will unwind the rate hike expectations when it sees INR stabilizing and inflation coming off on lower food prices in the economy.
The bond market is concerned by the reaction of the INR when the RBI stops providing swap facilities at fixed rates to the OMCs that are ever hungry for USD given the import dependence on crude oil. A sharp drop in value of the INR on removal of the swap window for OMCs will signal that the RBI will have to keep liquidity tight in the system.
The FCNR B swap window for banks has seen inflows of USD 12 billion into the system. The window is open till the 30th of November and on closure of this window, the inflows of USD will stop and this could lead to pressure on the INR. RBI may extend this window if it sees further volatility in the currency markets but given that the Fed is continuing its assets purchases of USD 85 billion a month, currency markets are unlikely to see the volatility that it saw in the June – September 2013 period.
Liquidity conditions are still tight in the system and this is keeping overnight money market rates closer to the MSF rate of 8.75%. The system is borrowing Rs 40,000 crores in the LAF (Liquidity Adjustment Facility), Rs 38,500 crores in term repo (cut off was at 8.30% in the 14 day term repo auction) and Rs 14,000 crores in MSF (as of 31st October 2013). The market will look for liquidity to ease in the system and overnight rates to fall to levels closer to repo rate of 7.75%.
Inflation numbers for November will play a key role in market expectations for a 25bs repo rate hike in December. Food inflation coming off sharply from 18% levels seen in September 2013 will have a strong negative effect on both WPI and CPI. RBI is trying to manage growth – inflation dynamics and will view falling inflation positively.
Corporate bond market saw mixed trend in yields with two and five year AAA bond yields rising by 5bps and 10bps week on week respectively while ten year AAA bond yields stayed flat. Five year credit spreads rose 5bps while ten year credit spreads fell 10bps week on week. Credit spreads are likely to stay ranged at levels of 75bps and 60bps for five and ten year bonds respectively given lack of clear direction on rates and liquidity.
OIS (Overnight Index Swaps) markets saw one year OIS yields rising by 3bps and five year OIS yields rising by 2bps week on week. OIS yields are likely to be ranged at current levels of 8.41% on one year OIS and 8.25% on five year OIS given liquidity being tight in the system.