The Hindu Business Line : Bond traders cautious on rising oil prices

BONDS remained steady last week despite surge in foreign currency inflows as traders preferred to remain cautious due to rising oil prices in the global markets.

Oil prices touched record levels in recent weeks at $55 a barrel. As a result, oil majors were in the market taking advantage of the rupee appreciation, to partially neutralise the impact of high oil prices. During the last six months, the rupee has appreciated by about six per cent, though from last year's levels it was almost steady. Along with oil majors, several corporates also took advantage of the rupee's appreciation, opting for prepayments of their foreign currency loans or swapping to domestic currency loans.

Liquidity: Despite these developments, liquidity continued to build up in the markets, prompting the RBI's sterilisation interventions. Through one-day reverse repos, the RBI mopped up upwards of Rs 30,000 crore per day. At the three-day reverse repos, the RBI mopped up around Rs 33,000 crore.

Despite these aggressive interventions, the 91-day T-bill yield remained steady during last week's auctions at 5.20 per cent, as against the previous week's 5.21 per cent. The 10-year yield to maturity was also steady at 6.65 per cent on a weighted average basis, marginally down from previous week's 6.67 per cent.

Low volumes: Traders said that despite this stability, the undertone in the markets was weak throughout last week, evident from low trading volumes. The average daily trading volumes were below Rs 3,000 crore during the week. Moreover, traders said that the outlook for the bonds was also bearish. This was evident from the slight widening spreads in the markets. Spreads between one year and 23 years were close to 145 basis points, up from the previous week's 143 basis points.

Spreads normally tend to narrow when the outlook is bullish.

Real yields: The spreads were also partly driven by the changes in the real yields. Inflation data last week moved to 4.95 per cent, up from previous week's 4.83 per cent. This implied that real yields actually narrowed for one year onwards.

The uptick in inflation ensured that real yields for one year softened to 70 basis points.

The bearish outlook was also driven by international factors. One element driving yields was the anticipated increase in US interest rates. Another round of hikes were expected in the US Fed funds deposit rates. The US Federal deficits and widening US trade deficits were likely to exert pressure on dollar interest rates.

In reality this has so far not happened.

US treasuries: This was partly because, countries like China continued to purchase US treasuries.

This has created a situation where long dollar yields were falling and short yields were rising. The 30-year dollar yields were 4.77 per cent for the dollar whereas one year yields were 3.66 per cent, as a result of the large purchases of US treasuries by China and Japan out of their current account surpluses.

This increasingly implied that the dollar yield curve was becoming flat and was likely to get inverted if the current trends in the markets continued.

However, countries like India have quietly begun discouraging large inflows. This was evident from the fact that the RBI has begun allowing the rupee to appreciate.

Forward premiums: Traders said that RBI has already slowed down interventions in the forward markets, evident from the fact forward premiums have considerably narrowed. Six and 12-month forward premia were below 1.6 per cent. This move was also being resorted to partly quell any possible inflation due to the large liquidity build up.

Prepayments: Another strategy being resorted was encouragement of corporate debt prepayments. This has started taking place because with the spike in international rates, corporates were at a far more advantageous situation borrowing in the domestic markets. Besides, this also reduces the burden of sterilisation on the RBI.

The costs of sterilisation were evident from the $1.9 billion inflows, which has pushed the foreign exchange reserves to a record high $137.559 billion. The bulk of these reserves were parked in US treasuries, particularly short-term. Bankers believe that for treasury management purposes the RBI's preference would be for the short-end of the yield curve, particularly one year and below. This would still mean a straight deficit of over 1.5 per cent, on the basis of the difference between the reverse repo rate and the one-year US Treasury yields.

Parking reserves: In reality though the deficit was likely to be slight narrower, partly because during the last few months, the currency reserves were also being parked in euro and sterling-denominated securities.

Despite such deft treasury management there were still deficits, because there has been little competitive hikes in interest rates by the European Central Bank. The options, therefore, before was to encourage more imports of capital goods and use at least the non-volatile components of the exchange reserves for meeting long-term infrastructure funding requirements. This has already begun; trade deficits were likely to return for a brief period prompted by capital goods imports.

Moreover, what was also expected to push up interest rates in the markets were the credit demand.

Credit demand continued to remain buoyant towards the month-end as bankers pushed for meeting year-end targets for bolstering bottomlines.

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