The Rs 13,000 crores government bond auction held on Friday the 19th of October saw strong bidding for bonds in the auction by market participants leading to cut offs coming in better than expected. The 19th October bond auction, which was the last auction before the 30th October Monetary Policy Review of the RBI, was used by traders to build positions on rate cut expectations. The auction received bids worth more than 3.4 times the auction size indicating the heavy demand for government bonds.
The bonds auctioned were the 8.19% 2020 bond for Rs 3000 crores, the 8.20% 2025 bond for Rs 7000 crores and the 8.83% 2041 bond for Rs 3000 crores. The cut offs came in at week’s low yields of 8.16%, 8.19% and 8.35% respectively. The strong cut offs in the auction drove down the ten year benchmark bond yield to levels last seen in July 2012. The 8.15% 2022 saw yields close the week at 8.13%, down 4bps week on week.
The last trading week before the policy review is a holiday shortened week with only three trading days for the week. The market will stay bullish until the policy review and there will be more demand for bonds from those who have not positioned for rate cuts. The yield on the 8.15% 2022 bond will trend down lower as demand outstrips supply in the run up to the policy.
The RBI is likely to cut the key policy rate of repo, which is currently at 8% levels, in its policy review. The market at this point of time is factoring in a 25bps repo rate cut. The rate cut expectations would have been higher if inflation for September 2012 had come in lower. Inflation as measured by the WPI (Wholesale Price Inflation) came in at 7.81% for September 2012, up from 7.55% levels seen in August 2012. September 2012 inflation is also the highest for calendar year 2012 to date. Inflation was driven up by the fuel price hike made in September by the government.
The swap curve is factoring in repo rate cuts with five year and one year OIS (Overnight Index Swaps) yields closing down 4bps and 3bps week on week respectively. Five year OIS yields are at 6.98% and one year OIS yields are at 7.60% making the curve inverted by 62bps. One year OIS yields are help up by deficit liquidity conditions forcing the market to borrow from the RBI at the repo rate of 8% on a daily basis. Five year OIS yields are expecting a sharp slowdown in the economy leading to more rate cuts down the line.
Liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI tightened last week with bids for repo averaging Rs 87,000 crores on a daily basis against an average of Rs 61,000 crores seen in the week before last. The source of liquidity tightening is difficult to pin point, as there has not been any extraordinary rise in credit growth or even currency in circulation over the last few months. Credit growth and deposit growth in absolute terms have almost matched out since end August 2012 while money in circulation has fallen in the August-October 2012 period. One reason for rising deficit could be the maturing of outstanding forward currency sale contracts of the RBI, which stood at over USD 12 billion as of August 2012. The details of timing of this forward contract maturity are not published and it is only a guess that it has affected liquidity.
Corporate bond yields closed almost flat week on week as markets digested low credit spreads of around 60bps in the five and ten year AAA bonds. Two year AAA bond yields fell on the back of curve corrections. Corporate bonds yields will stay steady at current levels of 8.55%, 8.70%, 8.85% and 8.90% in the one, two, five and ten year AAA bonds.