The Hindu Business Line : Bond bulls have many reasons to cheer

The remarks by the RBI Governor which suggested that the central bank will be far from aggressive in mopping up liquidity from the system gave further comfort to the bond bulls.

BONDS have rallied in the last fortnight behind the launch of MSBs (Market Stabilisation Bonds) getting postponed to April and a complete absence of any material profit-booking by PSU banks.

A Finance Ministry official has said that the MSBs shall `shortly be approved', which means that the Ministry has not even approved the programme yet and the market feared a large issuance any moment. We might actually find an MSB issuance schedule with the next year's borrowing calendar, which is due to come out on March 25.

The remarks by the RBI Governor which suggested that the central bank will be far from aggressive in mopping liquidity from the system gave further comfort to the bond bulls. He said that the MSBs will be carefully meshed with the next year's borrowing programme in such a way that the liquidity mopping exercise will not even be noticeable.

With more than Rs 50,000 crore in the repo, no year-end profit booking by banks, a go-slow hinted by the central bank on the MSB issuance, a large sovereign bond maturity in the last week of March with no commensurate issuance and a sharp fall in the headline inflation number; what more can the bond market ask for?

Although the fall in the year-on-year inflation rate was widely expected as there was a large base effect this week, unlike many earlier occasions, a flat index this time helped in realising the full impact of the base effect.

Thanks to this base effect, the headline inflation number (which I think is meaningless but is still relevant to the market) shall continue to show a stable to a mildly downward bias for the next couple of months. With the given liquidity and the accommodative central bank stance, the overall bullish sentiment should continue till the April monetary policy at least.

Even a jobless US recovery has put a seed of doubt with regards to the extent and sustainability of such a recovery. An interest rate hike that looked imminent in the US looks like getting postponed by at least another six months, if not more. Some bond houses have actually started calling for a hike only in 2006, bonds have rallied by 30-40 basis points in the last week.

Although there are few direct linkages between the interest rate environments in the US and that in India in the short term, but the local bond market will continue to derive comfort from the on hold policy of the Fed.

To reiterate what I had said the last time, I do not expect any rate cuts in India over the next three months and thereby any sharp and secular fall in rates is completely ruled out. But the above factors should cause a minor drift down in yields thereby giving a small window of opportunity to the bond traders to make a bit of money. You could see the 10-year sovereign yield drop down to 5.10 per cent or maybe even 5 per cent in an overshoot. Even the 10 cross 15 spread should shrink further as yields drift lower and the market starts gaining confidence.

Based on the bond market strength, the 5-year OIS has also drifted lower by 10-odd basis points in the last week. At 4.90 currently, it has room to fall further by another 10-15 basis points over the next month. We should see the one-year back at 4.50 and the 5-years at 4.75 per cent by April 15.

The MIFORs seem a bit tricky at these levels. With the five years at 3.55, it is vulnerable to a jump in the forwards or a pull back in US yields. The cash dollar situation seems to have suddenly improved quite substantially which can actually push forwards higher over the next week.

But technically, the MIFOR market looks very light; traders do not seem to have much position. So in the absence of any reversal of the overall theme, any move up in the MIFORs should be taken as an opportunity to receive some.

I do not see much of a spread play in this curve but given the technical positioning, receiving the 5 years is safer.

(The author is a senior trader, interest rates at HSBC, Mumbai. The views expressed herein are his own and not necessarily those of his employer.)