In the five trading days that have gone by since, the dust has well and truly settled.
Going by price action during the week gone by and the result of Friday’s Rs 31,000 crore primary debt auction, the bond market has accepted that for now rekindling economic growth remains the central bank’s top priority.
Interpreting monetary policy statements is no easy task. As a veteran bond trader quipped, “Even if you have 20 years of experience, you will always have butterflies in your stomach when the policy is being read out.”
What caused the market to worry was a sharp upward revision in RBI’s forecast for Consumer Price Index-based inflation for this financial year – a step which in another day and age would normally be a precursor to tightening of monetary policy.
However, amid the Black Swan event that is Covid, what was hitherto accepted as normal does not apply anymore. While the market does expect RBI to start the process of tightening –through reverse repo hikes – sometime between December and February, the broad consensus now is that any shift will be well telegraphed to the sovereign debt market.
For bond traders, the most important question is not so much about when the liquidity adjustment facility corridor will be narrowed. Rather, it is more about how RBI will wean the market off the huge amount of liquidity sloshing around in the banking system.
One source of comfort that has emerged from the policy is that while the quantum of reverse repo operations has been raised. The tenure of such operations has not been increased from the present tranche of 14 days. A longer tenure for reverse repos would signal central bank intentions to move towards more durable removal of liquidity.
MARKET DYNAMICS
A telling sign of the market’s acceptance of new realities is that the ferocious selling pressure that had afflicted the two most liquid bonds and the 10-year benchmark bond since May, has abated.
After witnessing a rise of 14 basis points in its yield in around three-and-a-half weeks, yield on the 10-year benchmark 6.10%, 2031 benchmark bond has settled around the 6.23-6.25% range over the last week.
Bond prices and yields move inversely and in the case of a 10-year paper a movement of one basis point in yield typically corresponds to around 7 paise in its price.
A key reason behind this is the fact that traders are left with few options when it comes to expressing a view on interest rates or government finances in the bond market.
Of late, RBI has been concentrating its open market purchases of government bonds under the G-SAP to illiquid papers in a bid to smoothen out chinks in the bond yield curve.
However, with RBI recently including liquid papers such as the 5.63%, 2026 bond in its open market operations under the Government Securities Acquisition Programme, bond traders are wary of taking short positions in highly traded bonds, lest they are announced as candidates for purchase by the central bank.
On the other hand, taking a favourable view on bonds at the current juncture, or to put it another way, betting on a fall in yields, is not exactly feasible.
No matter the lens through which one views it, market fundamentals do not warrant a rally in the bond market. CPI inflation may have eased to a three-month low of 5.59% in July, but the price gauge is still well above RBI’s medium-term target of 4.00%.
Bond 101 states that inflation is the market’s biggest enemy as it erodes the fixed returns of the asset class. “We are thinking of some partial reversal in December and then in February. That is the base case that we are assuming. We have been there for a while now. The reversal will of course not be on the repo rate but more on the reverse repo rate and getting aligned to a corridor of 25 basis points,” Shailendra Jhingan, Managing Director and Chief Executive Officer, ICICI Securities Primary Dealership said.
On the other hand, while the government is likely to meet the upwardly revised fiscal deficit target of 6.8% for this financial year, the government’s market borrowing programme – which represents the gross bond supply the market absorbs – is near all-time highs.
Most analysts agree the country’s debt-to-GDP ratio is unlikely to decline meaningfully anytime soon. “The CPI number was marginally better… It’s not significantly better. For us, the core inflation was a little higher than what we thought, food came down a little more,” Jhingan said.
“Supply has kept the yields from going down too much. We are looking forward to the calendar for the second half, where probably the supply will be a little lower. But then, the market would be anxious about what kind of a G-SAP amount comes, whether it comes or not, or whether RBI decides to do only Operation Twist. I don’t see much joy in terms of yields coming down.” he said.
The government announced a gross market borrowing programme of Rs 12.06 lakh crore for this year.
In the current scheme of things, perhaps, the best strategy for traders is to sit tight and exploit hefty returns from some bonds amid a record-low cost of borrowing, treasury officials said.
Trading gains may be few and far between but the recent correction in bond yields does provide an opportunity.
Yields on the two most traded bonds currently, – the 5.63%, 2026 bond and the 6.64%, 2035 bond have climbed more than 10 basis points since May.
“At some part of the curve, yields have become attractive. For instance, the 14-year bond is now at 6.90%. This is where it used to trade in pre-pandemic times,” Jhingan said.
“The long-end yields have corrected a lot. I think the market is showing some interest in that segment. As far as the short-end is concerned, the rally looks difficult there because it’s already trading at levels where the best of news in terms of when the reversal will happen is kind of priced in,” he said.
Friday’s auction bears testament to the fact that the market has made its peace; albeit momentarily, with the way things are.
The primary auction worth Rs 31,000 crore was a sale, which after quite some time did not witness either a devolvement or a rejection of bids, with the RBI even exercising the greenshoe option in each of the four bonds up for sale to take up a total of Rs 36,495 crore.
NEW BENCHMARK, SAME OLD STORY
Over the last couple of years, it seems, the role of the 10-yer benchmark government bond – the reference point for a gamut of India’s credit products – has been relegated to a silent observer.
Market participants informed RBI that the 6.10%, 2031 bond is likely to suffer the same fate as its predecessor if the central bank does not stop hoovering huge quantities of the 10-year benchmark bond in its quest to anchor sovereign borrowing costs.
To be fair to RBI, it has not adopted the same strategy for the 6.10%, 2031 bond as it had for the 5.85%, 2030 bond. Still, trade volumes of the 10-year benchmark bond are miniscule and the bond regularly features as the 7
th or 8
th most traded paper in the secondary market. Strange times, indeed.
A point to be noted here is that in its quest to prevent a runaway rise in yields on the day of the policy statement (last Friday), the RBI rejected all bids for the 6.10%, 2031 bond at a primary auction.
“Very few people hold the bond. It has not yet reached the critical mass of at least Rs 30,000 crore. So there is no trade. But, this bond presents a dilemma for RBI. If RBI doesn’t buy, yield will rise. If RBI does buy, it will become rapidly illiquid. The situation is complicated,” a senior treasury official at a large foreign bank said.