The Hindu Business Line : The 10 cross 20 spread should shrink by 20 bps

The fact that all the banks will have the flexibility of putting money in the seven days repo and borrowing overnight, the overnight rate will hopefully be only marginally lower than the repo rate.

THE about Rs 36,000 crore of market stabilisation bonds (MSBs) in the first quarter of the next fiscal seems rather large.

But as the RBI Governor had said, the issuance is well spread out and carefully meshed with the borrowing programme. To suit the requirements of all, a combination of 91-day and 364-day T-bills and bonds of up to two years maturity have been used to remove liquidity under the MSB programme.

Given the abundant liquidity, I wonder as to why has the central bank used 91-day T-bills so extensively under this programme; it will remove liquidity for a very short period of time. In another three months, it will have to issue these bills all over again which will not only increase the gross issuance but also cause some kind of a psychological congestion in the borrowing schedule.

The current core excess liquidity in the system is upwards of Rs 50,000 crore. This should increase to about Rs 70,000 crore by mid-April, once the government loosens its purse strings a bit. With Rs 70,000 crore sloshing around and more to come on account of further dollar purchases by the central bank, Rs 36,000 crore of MSBs is not as large as it seems in the first glance. But it is bound to cause some fatigue in the short end. The one-year T-bill rate should go back to around 4.50 per cent.

The key, however, is how the central bank implements the new LAF. There is some speculation that the central bank might reduce the target overnight rate from the current 4.50 per cent level.

Given the current inflation scenario, I do not think that the central bank should and will reduce the target overnight rate. However, once the daily one-day repo is replaced by daily seven-day repos at 4.50 per cent, the overnight rate might settle at a marginally lower level. The fact that all the banks will have the flexibility of putting money in the seven days repo and borrowing overnight, the overnight rate will hopefully be only marginally lower than the repo rate.

The government's borrowing programme for the first quarter next fiscal seems soft and well spaced out. The net borrowing in the given period is only about Rs 11,000 crore. The amount of Rs 5,000 crore for April and May each and about Rs 1,000 crore in June is all that the government is slated to borrow, net of maturities. Even on a gross basis, Rs 32,000 crore is not large for a quarter.

We should see some debt swaps and hence some borrowings by the State governments, but that hardly puts pressure on the sovereign yield curve. It should only push up the Centre-State credit spread to a more realistic level.

The small borrowing number, liquidity and benign headline inflation for the month of April bodes well for the bonds. The 5.05 target on 10-years continues to be in place. The 10 cross 20-year yield spread, however, should shrink by a good 20 basis points from the current levels. The spread between 2017 and 2022 maturity benchmarks continues to be almost 10 basis points a year, which should go down to at least seven. The 2014 over 2017 spread should also come down by another five basis points or so, there by taking the 10 cross 20 spread shrinkage tally to about 20 basis points.

So one should continue to be long bonds, with a larger proportion of risk in the long end.

The April-February trade data was no different from the earlier months; the trade deficit continues to grow at 100 per cent over last year. Exports were up some 36 per cent for the month of February whereas imports grew by almost 44 per cent.

At this pace, the widening trade deficit will ensure that the small current account surplus that India has started to post from the last six quarters gets wiped out. But as long as the capital account inflows keep pouring in, the widening trade deficit does not seem to impact the sentiment on the rupee in any way.

It has appreciated by almost two per cent in the last week, after the central bank moved away from aggressively supporting the dollar.

We have finally seen some ECB related paying happening on the MIFOR (Mumbai Implied Forward Offer Rate) curve. Some more paying seems to be further lined up, which can cause the MIFOR curve to move up a bit.

But the overall theme has not changed and one should again be looking to receive if the 5-year MIFOR moves up into the 3.65-70 range.

(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.)