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Fixed income markets suffered a further setback last week with bond yields inching up further on all-round selling. A sharp spike in the May headline and core WPI inflation, further escalation of tensions in Iraq leading to Brent crude price jumping to $115/bl, sustained pressure on the rupee and scanty monsoon rains provided no respite to the weakening momentum that started in the previous week. May WPI accelerated at its quickest pace since December 2013 to climb to 6.01%, beating analyst estimates of 5.2-5.3% by a wide margin. Core inflation also unexpectedly rose by 44 bps to 3.84% from 3.40% last month.
Following the sharp spike in oil prices after news on attack on a major refinery in Iraq, the rupee also remained under pressure and ended near a six-week low at 60.18, after depreciating to an intra-week low of 60.50, down from 59.77 in previous week. Reassuring comments from RBI that India had comfortable forex reserves to deal with any external shock arising from Iraq crisis and from Finmin sources that the borrowing programme for the current fiscal was unlikely to change materially also only provided temporary support with selling resuming after a short-lived rebound. At the FOMC meeting last week, the Fed cut the bond buying program by another $10bn, while maintaining dovish undertone despite rising CPI expectations. Benchmark 10-year government bonds eventually ended at 8.72% up by 13 bps from 8.59% last week. Five year AAA bonds rose 10 bps from 9.09% to 9.19%, while 10 year AAA bonds closed higher by 6 bps to 9.14% from 9.08%. The US 10 year treasury continued to trade in the band of 2.60%-2.64%, after testing 2.57% post the Fed guidance.
The liquidity situation was tight in the initial part of the week due to scheduled advance tax payments as overnight collateralised borrowing and lending obligation rates hovered in wide range of 8.25% to 9.00%. To address the prevailing tight liquidity situation RBI announced two day term repo of Rs 10,000 rolling it over for further seven days which resulted in overnight rates cooling off to near a repo rate of 8%. The weighted average cut off in two day and seven day term repos stood at 8.07% and 8.04% respectively. The liquidity adjustment facility borrowings declined to Rs 11,626 crore from Rs 14,125 crore. Marginal standing facility borrowings were negligible. The short end rates were broadly stable with three month bank certificate of deposit rates ending 1 bp higher from 8.55% to 8.56%, while one year CD rates saw marginal uptick of 4 bps from 8.88% to 8.92% led by weakness in the rupee forwards and overnight index swap curves.
The bond markets are expected to trade cautiously till there is some resolution in sight on the Iraq situation. Despite an ongoing unrest in Iraq, oil exports from the region have stayed normal. Thus the current spike in crude prices may reverse if the diplomatic intervention by US military advisors helps in pacifying the prevailing situation. On domestic front all the statements made by Finmin sources point to an adherence to fiscal consolidation path. At this juncture it seems that the markets have overplayed the Iraq event and there is a possibility of some improvement from here. The short end of the curve will continue to remain a defensive and a carry bet.
Mahendra Jajoo is Executive Director & CIO-fixed income at Pramerica Asset Managers
