Inflation fears to push up bond yields

The US Federal Reserve (Fed) cut the benchmark Fed rate by 50 bps last week as a pre-emptive strike against recession. The markets were expecting a 25 bps cut, and the 50 bps cut spurred a violent move.

Equities rallied, the dollar weakened, bond yields rose and commodities rallied. Equities, especially emerging market equities, rallied, with India, Brazil, Hong Kong closing the week at all-time highs.

The dollar fell sharply against the euro as well as against emerging market currencies. The dollar/rupee closed the week at multi-year lows at Rs 39.80 levels.

Bond yields in the US rose, with the ten year benchmark treasury yield rising by 20 bps as markets perceived the Fed action as inflationary. Domestic bond yields closed down on expectations that the RBI (Reserve Bank of India) may not hike rates further on the back of the Fed action. Commodities rallied with crude oil and gold closing the week at $81.7/barrel and $738/ ounce, respectively.

The Fed action is a headache for the RBI. The broad dollar weakness on the back of the Fed rate cut and emerging signs of recession in the US has increased liquidity flows into emerging market assets. The Fed rate cut has also taken up oil and commodity prices sharply higher.

Inflation in India is set to go higher as all three primary components of inflation are seeing hefty price increases. The potential for asset bubbles has gone up on the back of liquidity flows while inflation is a direct tax on the poor, especially in emerging markets.

The RBI will up its ante against any form of inflationary pressures and economic instability caused by asset bubbles. The RBI will use liquidity tools such as CRR (cash reserve ratio) and MSS (market stabilisation scheme) bonds to keep liquidity in check. Bond yields should harden from current levels on the back of RBI policy actions.

The RBI has announced MSS actions for Rs 15,000 crore for this week. The auctions include Rs 5000 crore of treasury bills and Rs 10,000 crore of dated government securities. The auctions will drive up yields at the short end of the curve on increased supply.

Liquidity outlook is positive with advance tax flows of around Rs 30,000 crore expected to come back into the system.

Portfolio flows would also contribute to higher liquidity.

Liquidity, as measured by bids for reverse repo/ repo in the LAF (liquidity adjustment facility) of the RBI, was down on the back of advance tax outflows of around Rs 30,000 crore.

The market saw RBI injecting money into the system on the last day of the week as liquidity tightened. The overnight rates trended higher on tightening liquidity with call rates moving up to 7.5% levels.

Government bonds

Government bond yields closed down last week on the back of Fed rate cut. The yield on the benchmark ten-year (7.99% 2017) bond closed last week at 7.82% as against 7.86% levels seen in the week prior to last.

Five-year benchmark bond yields closed down 4 bps, with the yield on the 7.40% 2012 bond closing at 7.67% levels. Yields on the long bond (8.33% 2036) closed flat at 8.36% levels. The five over thirty segment of the curve steepened by 8 bps to close the week at 68 bps levels.

The RBI has announced gilt auctions under MSS for this week. The bonds to be auctioned are the 5.48% 2009 bonds and the 5.87% 2010 bonds for Rs 5,000 crore each. The auctions should see cut-offs coming in at higher levels of yields on increased supply fears.

T-Bills, corporate bonds and overnight index swaps

Treasury bills (T-bills) yields moved down last week on the back of the Fed rate cut. The cut-off on the 91-day T-bill auction held on September 19 came in at 6.98% against a cut off of 7.10% in the week earlier to last.

The 182-day T-bill auction saw the cut off at 7.25% against 7.40% seen in the previous auction. The RBI is auctioning Rs 3,500 crore of 91-day and Rs 3,000 crore of 182-day T-bills this week including Rs 3,000 crore of 91-day and Rs 2,000 crore of 364-day T-bills under MSS.

Corporate bonds saw yields down as government bond yields fell. Five-year AAA papers were quoting at 9.60%-9.65%, down 10bps week on week. The five-year AAA spreads were lower by around 7 bps at 183 bps levels. Credit spreads are going to trend higher as higher supply will keep yields pressured.

Overnight index swaps (OIS) saw yields drop on the back of the Fed rate cut. The one over five curve steepened by 12 bps week on week. The one-year OIS yield closed last week at 6.87% levels, down 17 bps week on week.

The five-year OIS yield closed down 5 bps at 7.08% levels. The one over five spread closed at 21 bps. Swaps will look to move higher as MSS supply keeps levels firm at the short end.

The author is head, portfolio management services, Sundaram BNP Paribas AMC. The views expressed by the author are his own and need not represent the views of the organisation in which he works.