Oil price, rate hike prospects to pressure yields

The market is faced with the double whammy of fuel price hikes and rate hikes, and this will keep yields pressured at higher levels.

However, once the hikes are through, there will be a tendency for yields to rally from higher levels.

The government is expected to hike fuel prices in the very near future in order to reduce the subsidy burden due to high crude oil prices. Oil prices at $123/bbl (brent crude) is leading to a projected subsidy bill of over Rs200,000 crore for the full year 2011-12. The government has not budgeted for such a high subsidy bill (budgeting only for Rs23,640 crore) and has indicated that they will raise fuel prices to reduce the subsidy burden. Rise in selling price of fuel will lead to inflation expectations trending higher as fuel accounts for around 15% of the wholesale price index (WPI). Higher fuel prices leads to a rise in manufacturing price inflation due to rise in input costs. Inflation as measured by the WPI for the month of March 2011 came in at 8.98% as against market expectations of 8.4% and the Reserve Bank of India (RBI) forecast of 8%. The RBI, which was expected to raise policy rates by 25 basis points (bps) in their policy meeting in the first week of May, is now expected to raise rates by 50 bps to quell rising inflation expectations. Bond yields will remain pressured till the fuel price hike and the RBI policy moves. However, once the event is over, the market will tend to look ahead and given what it sees ahead, will drive bond yields lower or higher.

I expect the market to drive bond yields lower after the fuel price and policy rate hikes. The reasons are a) inflation is expected to come down from higher levels in the second half of this fiscal as prices stabilise at already elevated levels b) rate hikes of 50 bps by the RBI will bring down incremental rate hike forecasts c) liquidity is good in the system after a long period of tight liquidity (ten months of negative system liquidity) and d) the market will look for a rally given that bond yields are trading at close to three year highs.

The swap curve moved up week on week on the back of rising inflation expectations and on the back of rate hike expectations.

The one-year overnight index swaps (OIS) yield moved up by 12 bps, while the five-year OIS yield moved up by 3 bps week on week. The curve flattened with the five over one spread coming off by 9 bps to close the week at 45 bps levels. The curve will tend to flatten further as rate hikes will keep one-year OIS yields pressured, while five-year OIS yields will take direction from bond yield movements.

Liquidity is high in the system on the back of government spending. The government had drawn down Rs50,000 crore overdraft from the RBI as of April 15, 2011 and the RBI had to issue cash management bills for Rs20,000 crore to bring down the overdraft. Banks had parked over Rs110,000 crore with liquid fund schemes of mutual funds as of April 8, indicating good system liquidity. Liquidity is expected to remain easy on account of government spending.

Government bond auction
The government auctioned Rs12,000 crore of bonds last week. The bonds auctioned were the 7.83% 2018 bond for Rs3,000 crore, the 7.80% 2021 bond for Rs6,000 crore and the 8.30% 2040 bond for Rs3,000 crore. The cut-offs came in at 8.10%, 8.06% and 8.50%, respectively. The RBI auctioned Rs20,000 crore of cash management bills last week. The cut-off on the 63-day bill came in at 7.27%, the cut-off on the 70-day bill came in at 7.35% and the cut-off on the 49-day bill came in at 7.37%. There are no government bond auctions scheduled for this week.

(Source: http://www.dnaindia.com/money/column_oil-price-rate-hike-prospects-to-pressure-yields_1535800)