The bond market raised bets of a repo rate hike in the 29th October 2013 monetary policy review of the RBI by taking up bond yields post the release of the WPI (Wholesale Price Index) numbers. Bond yields rose across the curve with yields on the 7.28% 2019 bond, the 7.16% 2023 bond and the 8.27% 2027 bond rising by 16bps, 6bps and 5bps respectively.
Inflation as measured by the WPI came in at a seven month high of 6.46% for the month of September 2013. Food inflation at 18.4% led the WPI higher while manufacturing inflation was at 2.1% levels. The bond market believes that the RBI will look at the overall inflation rather than splitting it into food and manufacturing inflation and hence is factoring in a repo rate hike of 25bps on the 29th of October.
The RBI governor, Dr. Raghuram Rajan has shown an inclination towards a steeper yield curve. His policy moves of lowering the MSF rate, buying bonds through OMO (Open Market Operations) and conducting 7 and 14 day term repo auctions suggest that he would like overnight rates coming off and liquidity easing in the system. The 25bps hike in the repo rate in the September policy review indicates that Rajan is signaling higher long term rates given rising inflation expectations.
The yield curves across market segments have flattened out from inverted levels but are yet to show steepening. One, five and ten year government bond yields are trading at levels of 8.5% to 8.6%. Corporate bond yield curve is flat with two, three, five and ten year benchmark AAA bonds all trading at 9.4% to 9.55% levels. The five over one OIS (Overnight Index Swap) spread is inverted at 23bps levels.
RBI will not be able to maneuver the yield curve to make it steeper by raising the repo rate and rolling back the liquidity tightening measures that it adopted in July and August 2013 to stem the fall of the INR. Higher repo rates coupled with deficit system liquidity will keep yields at the short end of the yield curve higher than yields at the long end of the yield curve as the market factors in slowing economic growth in bond yields.
The central bank will have to look at taking system liquidity to surplus from deficit for it to achieve its objectives of a steeper yield curve. The corridor between the reverse repo rate and the repo rate, which is 100bps, will have to be played for the RBI to maneuver the yield curve to its desired position. A system surplus is liquidity will see overnight rates coming off by close to 100bps leading to a fall in yields at the short end of the yield curve.
The question is, how can the RBI take liquidity into surplus mode? Banks are borrowing around Rs 97,000 crores from the RBI on a daily basis (including term repos) and in the festive season, demand for funds is high. RBI cannot pump in money through OMO as it leads to rising inflation expectations. The central bank is not in a position to buy USD to shore up reserves as the INR is still trading at lower levels of Rs 61.30 against levels of Rs 54 seen in April 2013. Easing CRR (Cash Reserve Ratio) or SLR (Statutory Liquidity Ratio) is not warranted if RBI is targeting inflation. The market will watch for signs of easing system liquidity before it moves towards steepening yield curves.