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Yields Go Dip, Dip, Dip

With yields at historic lows, markets remain dull awaiting a trigger. The delayed RBI auction expected in the coming week will set the market tone

The Reserve Bank of India surprised the Bond Street by holding back an auction announcement this week. The sale of government bonds was widely expected after the CRR cut infused another Rs 6,000 crore in a liquidity-flush market with yields dipping to historic lows. The auction "fear" also kept the otherwise rampant bulls on a tight leash, who had earlier clobbered the yield on 10-year paper (11.5%, 2011) to an all-time low of 8.69 per cent on November 7. There has been no signal so far that the RBI is uncomfortable with current yields.

Much of the action for the week was concentrated at the longer end of the yield curve with high volumes beyond the 2012-2013 band. This segment still offers decent returns after the recent rally squeezed the spread between call markets and shorter bonds. For instance, while overnight funding cost is hovering around 6.6 per cent, the yield on the 2004 G-Sec is only at 6.96 per cent. The sentiment was also buoyed by the 50 basis points rate cut in the US coupled with Jalanspeak, favouring softer interest rates. However, the Fed rate cut also triggered some irrational exuberance with a section of the market expecting an immediate reduction in the repo rate.

After touching 20 per cent last week, call rates remained in the 6.4-6.7 per cent range on the back of abundant liquidity with little demand for funds. With overnight rates ruling low, RBI received large subscriptions in its repo auctions at 6.5 per cent and mopped up over Rs 33,500 crore. The rupee continued to trade steadily against the greenback with supplies from exporters and some foreign fund inflows. While inflation plummeted to a historic low of 2.72 per cent for the week ended October 20, 2001, it is a worrying factor and reflects the contracting demand in the economy.

The Tale of Two Economies
The Federal Reserve slashed interest rates for the 10th time in the current calendar to rev up US spending and brought down the Fed rate to a 40-year low of 2 per cent. Adjusted for inflation, as measured by the 2.6% year-over-year gain in the core consumer price index, the rate now is below zero. Yet, the economy has shown little sign of improving with rising job losses accentuating the slowdown. For one, the effects of lower interest rates have been blunted by the lack of cooperation from the financial markets. Thus, interest rates at the long-end continue to rule high, which prompted US Treasury to suspend the sale of 30-year bonds. On the other hand, yields on risky corporate bonds have soared, stifling the borrowings for most companies in the process.

The scene in India, if not identical, is also not very different from the US. While credit offtake has been slow, banks have also shied away from aggressive lending for fears of NPAs. The long-term interest rates have stayed firm - though the bank rate is now down to 6.5 per cent, the bluechip borrowers are still charged anywhere between 11.5 to 12.5 per cent with little disbursal at sub-PLR rates. The two-tier interest rate structure, courtesy government's small saving schemes has also prevented a sharper fall in interest rates. Further, as in the US, the falling demand and idle capacity has meant that businesses are also not rushing to invest. Importantly, the layoffs in the Indian markets, though not as sizeable and penetrating as in developed economies, has delayed at least some big budget spending.

Outlook
The yields are now at historic lows and markets are expected to be lacklustre till the next trigger. With two holidays in the reporting week, call rates could briefly firm up if banks are not adequately covered. While the RBI has delayed the auction, an announcement could come next week with the auction size setting the tone for the market. While a small-size auction could trigger a brief rally, a large issue may induce some hardening of yields. Though oil prices have remained largely stable, the OPEC countries are now planning a cut in production. However, its still early to predict the impact – one, it rests on the quantum of production cut and two, the spectre of global recession could lower demand. Yet, any large production cuts could spike oil prices and spur volatility in forex and bond markets.