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Fixed income markets turned bearish as monetary policy review came out more hawkish than anticipated with bond yields spiking well past the critical support level of 9%. Though RBI maintained status quo on key policy rates in line with market expectations, it reduced daily liquidity adjustment facility borrowing limit for banks to 0.25% from 0.5% of NDTL while increasing the borrowing limit through 7 day and 14 day term repos to 0.75% of NDTL implying a nominal increase in borrowing costs for the banking system.
Furthermore RBI scrapped the existing T-bills limits for foreign portfolio investors restricting them to invest only in government bonds of residual maturity of more than one year. On CPI front while highlighting potential upside risks to food inflation due to forecasted El Nino effects and expected revisions in administered prices of fuel, fertilizers and subsidies, Dr Rajan also acknowledged that food inflation has largely bottomed out. While giving forward guidance, he expressed satisfaction with the recent progress in disinflationary impact through stable exchange rate, negative output gap and Industrial workers inflation coming in at 6.78%. He reiterated that RBI shall not be acting on transient base effects on inflation prints. He signaled his intent to achieve 6% CPI inflation by January 2016 and thus practically ruling out any rate cut in 2014.
RBI also did not provide much comfort on possibility of open market operations purchases of bond which have helped the bond yields remain contained in last couple of years. Meanwhile, Brazil hiked the key rate by another 25 bps to 11% though signaling a possible end to ongoing tightening cycle. Benchmark 10 year yields back home ended at 9.06% rising a whopping 26 bps from 8.80% last week. The rupee weakened marginally to 60.08 from 59.89 on import related demand. Corporate bonds had a muted impact in absence of volumes. Five year AAA bonds rose 7 bps to 9.70% from 9.63%, while 10Y AAA bonds rose 7 bps to 9.70% from 9.63% leading to contraction over sovereign papers. In global markets the US dollar continued to gain on the back of favourable PMI prints and continued improvement in labour markets. The possibility of unconventional monetary easing to fight deflation fears in euro zone also helped the US 10 year yield inched up 6 bps to 2.75%.
Liquidity situation did not ease as anticipated due to reduction in the borrowings through daily LAF with immediate effect resulting in rush for product covering by banks during the reporting week. Overnight rates remained close to marginal standing facility rate for most part of the week. The overnight rates crashed below 8% following the additional Rs 20,000 crore 3 day term repo announcement by RBI. The weighted cut off rate on 3D term repo and regular 13 day term repo came in at 8.22% & 8.39% respectively. MSF borrowings also declined significantly. Three month PSU Bank CD rates fell 20 bps but 1 year Bank CD rates remained flattish at 9.18%.
Since the market seems to be in the tight grip of negative sentiments, some more hardening may be on the cards, however the impact is likely to be limited as most of the government bonds are yielding in the range of 9.25% to 9.50% in annualised terms. These are historically cheap valuations for Indian bonds. The government bond auction was well bid by investors even though there was some unsold amount at longer end. If similar phenomenon continues going forward relative value buying would emerge even in absence of open market operation support from RBI. Corporate bonds are likely to face headwinds this week given attractive valuations from government bonds. Buy on dips strategy is likely to play out on high probability of short covering given the magnitude of sell off in government bonds.
Mahendra Jajoo is Executive Director & CIO - Fixed Income at Pramerica Asset Managers
