The Hindu Business Line : Rates might take a breather for now

There is a small possibility of the central bank talking about the risk to the economy from high oil prices, which will be positive for bonds. So, it might make sense to go slightly long into the policy.

A FIXED rate auction for Rs 5,000 crore pushed up the 12-year yield by good 30 basis points.

It just goes to show how little appetite the market has for government bonds.

The public sector banks are conspicuous by their continued absence from the bond market for quite some time and it is hard to imagine the government pushing through its borrowing programme without their support.

At this point, it is difficult to say what will bring them back to the market.

It is clear that they are reluctant to take any risk which exposes them to mark-to-market volatility.

They have a healthily growing loan book and hence are less desperate to deploy cash.

Although the system is currently flush with liquidity, the situation might not be the same going ahead.

The first quarter of the financial year has historically seen large increases in currency expansion and thereby a reduction in bank liquidity. With oil prices close to their all-time highs and dwindling FII flows, I do not see any significant increases in RBI's forex reserves.

This will choke the primary source of growth in reserve money in the last few years, thereby putting pressure on the system liquidity.

There is no denying the fact that even if reserve money growth slows down, there is enough liquidity cushion in the form of outstanding MSS (Market Stabilisation Scheme) issuance.

But the central bank will be slow in letting the MSS money find its way into the system unless it is absolutely comfortable on the inflation front. In other words, the need to deploy cash will continue to be minimal.

In the current situation, the investor banks will come back to the market to buy bonds only for their `hold to maturity' books and that too, if they have a good carry. The current situation is just about getting there though.

It looks unlikely that the central bank will hike rates in its monetary policy, to be announced on Thursday.

One, the current year-on-year WPI inflation at 5.48 per cent is much lower than what the central bank had forecast and was willing to live with. Manufacturing inflation in the last six months has particularly slowed down; it has grown by an annualised rate of less than 1.5 per cent on a point-to-point basis in this period.

It has jumped a bit in the last three months, but is still lower than 3.50 per cent.

The US Fed , meanwhile, has moved on rates on all its recent meetings and is expected to continue doing so but looking at the US economic strength, one gets a feeling that they might have to stop at 3.75-4 per cent. Also, high oil prices are bound to slow down the world economies in the medium term.

The last set of data on domestic infrastructure and industrial production has already been far from encouraging. It might be a temporary soft patch, but in the circumstances it looks highly unlikely that the central bank will hike rates.

It will most likely continue with its October stance though. If it does not shift its monetary stance to a more hawkish one, then the current rates price in all of it.

In other words, no rate hike coupled with a continuation of the October monetary stance will most likely not cause another sell-off in bonds or paying on the swaps.

On the other hand, there is a small possibility of the central bank talking about the risk to the economy from high oil prices, which will be positive for bonds.

So, it might make sense to go slightly long into the policy.

With overnight rates expected to be around 4.75 per cent for quite some time, the 5-year government bonds at close to 6.75 per cent give a reasonable carry of 200 basis points.

Similarly, the 5-year OIS at 6.55 per cent looks like an attractive receive for now.

The next trigger after the policy will come from the May bond auction.

If the 5-9 year tenor auction scheduled for the first week of May is a fixed rate, one then you could see bond yields go up by another 10 basis points from the current levels.

Five-year OIS even then is unlikely to go above 6.60 per cent. But if the central bank decides to make it a floating one, then you could see a good rally.

The government is scheduled to borrow 20 per cent of its total requirement through floaters.

Given that the last two issuances have been fixed rate ones and there will be appetite for floaters in the short end only, this one could very well be a floater.

The RBI would have issued its third 182-day T-bill by May 4, so even the problem of not having the required benchmark will not be there.

The currency swap curve is the only one, which continues to look like a pay on dips.

The view on the currency has slowly changed.

The high current account deficit for the third quarter coupled with slowing capital flows makes the rupee vulnerable.

Atleast, all the one-way selling of dollar has stopped.

In this environment, the 5-year MIFOR to stay much below the 5-year OIS does not sound right.

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

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