Yields to take cues from Inflation and Policy meet

Highlights:

• The bonds remained jittery throughout the week; however, it settled down at low levels as compared to last week closures.

• The Industrial Output Data as measured by Index of Industrial Production (IIP) rose a more-than expected 13.8 per cent in July 2010, or nearly twice the 7.2 per cent seen in last month.

• Retail Inflation and Food Inflation rose over 15 per cent and 11 per cent, causing a concern for RBI which may hike the rates again.

• The market liquidity remained comfortable with the net absorption of Rs. 27,640 crore under LAF window. However, it would remain in deficit mode going forward.

• The market speculation that the current benchmark paper will be replaced have been put on hold after a Senior Finance Ministry official stated that there is adequate headroom in the current 10-year paper and the bond is expected to last for the entire borrowing in FY11.

View & Recommendations:

• The unexpected factory output at 13.8 per cent plus the high inflation figures may prompt the central bank RBI to revise the policy rates upwards. However, the market has already factored into the 25-bps hike in policy rates.

• Bond yields may soften further in view of global economic environment especially from US i.e. better than expected US Employment data.

• The absence of debt sale in the coming week will keep the demand for debt papers high. The real tone will be set after the mid-quarter policy review this week. Any positive surprise will be greeted with a rally in bond prices. The market is likely to focus on domestic data and policy measures. The policy meet will also review the awaited headline inflation figure due on Sept 14, 2010.

Broader Perspectives:
Bond Front
It is concerned that policy makers are running out of ammunition to control inflation and high factory output is also reigning in strongly; the RBI may go for an upward hike in policy rates. However, the mixed sentiments emanating from global markets are preventing RBI from taking any extreme measures. US President Barack Obama commented that US economy was taking longer than expected time to recover from economic shivers. However, the better-than-expected growth in US employment increased the odds of a fifth interest-rate hike this year.

Bond prices moved up with the 10-year benchmark yield witnessing a drop of 7 bps. The benchmark bond 7.80% 2020 yield nosedived from 7.98 per cent to 7.91 per cent. The comment by the Senior Finance Ministry over the continuance of the current 10-year benchmark bond for the remaining fiscal year 2010-11 boosted the sentiments among traders and investors which lapped the bond to make the prices attractive. He added that the government's preference was to borrow through papers of longer maturity, in order to evenly spread out its outstanding. However, the 8.13% G-Sec 2020 eased only 1 bps to 8.04 per cent. The G-Sec volume was also strong as reported in NDS-OM platform; it showed a daily average of Rs. 12,353 crore over the week. The 1-10 year spread also reported a sharp drop from 168 bps to 149 bps.

Bond Supply
The government auctioned securities worth Rs. 11,000 crore last week. The bonds auctioned were the 7.17% 2015 for Rs. 4,000 crore, the 8.13% 2022 for Rs. 4,000 crore and the 8.26% 2027 for Rs. 3,000 crore respectively. The cut-offs were in line with the market expectations which came in at 7.69 per cent, 8.02 per cent and 8.35 per cent. Five State Governments namely Maharashtra, Punjab, Tamil Nadu, Uttar Pradesh and West Bengal conducted the auction of their State Development Loans for combined amount of Rs. 5,300 crore on Sept 07, 2010. Their cut-off yields were in the range of 8.29 per cent to 8.41 per cent.

Liquidity
The liquidity was comfortable throughout the week as measured by bids for Repo and Reverse Repo auctions in Liquidity Adjustment Facility (LAF). The net absorption amount was Rs. 27,640 crore for this week. This week, there won’t be any auction which will ease off the liquidity. However, the advance tax outflow to the tune of Rs. 50,000 will put the liquidity in deficit mode. The average Call and CBLO rates dropped to 4.65 per cent and 4.28 per cent from 4.77 per cent and 4.75 per cent respectively over the week.

Corporate Bonds
Corporate bonds’ yields fell over the week. The 10-year AAA bond ended at a yield of around 8.71 per cent compared to 8.75 per cent. However, the 1-year bond hardened by 15 bps to 7.95 per cent from 7.80 per cent a week earlier. In the primary market, EXIM Bank raised Rs. 100 crore with 5-year paper and another Rs. 100 crore with 10-year paper with an annualized yield of 8.45 per cent and 8.68 per cent.