By: Punam Sharma
Our updates on RBI’s intervention to soothe bond markets are beginning to resemble a well received movie franchise; given the number of sequels. Be as it may, the RBI struck yet again yesterday (thrice by our count now; refer ‘RBI measures today”, dated 20th August and “RBI gives a yield signal; again” dated 3rd September for the other 2). Since the last monetary policy review when the central bank threw in a surprise repo rate hike, bond markets have been in a tizzy again with 10 year yield rising by 60 – 70 bps over the past few sessions. Even this doesn’t capture half of the total pain, given that the 10 year is about the only security that deals in the market with any reasonable volume these days. Illiquidity and term spreads have both continued to widen reflecting generalized lack of confidence in the market. Furthermore, 27% of the last auction devolved on primary dealers indicating muted appetite.
The RBI in its short press release yesterday states that ‘liquidity conditions have been tightening as reflected in the hardening of yields in the government securities market due to uncertainties around the Government borrowing programme for the second half of 2013-14 as well as the prospective effects of banks’ half-yearly account closure, the seasonal pick-up in credit demand, festival-related demand for currency and sluggish deposit growth. The Reserve Bank is closely and continuously monitoring liquidity conditions and will take actions as appropriate, including open market operations, to ensure that adequate liquidity is available to support the flow of credit to productive sectors of the economy’.
We would somewhat differ with this assessment and rather attribute movement in yields to the following:
1. While it is true that the RBI cut MSF by 75 bps in its last review, it hiked repo by 25 bps. The central bank may have believed that this amounts to net easing and therefore bond markets should behave accordingly. We would disagree. The MSF hike was projected as a temporary measure aimed at stemming rupee volatility. This view was endorsed by Raghuram Rajan himself in his earlier avatar as the chief economic advisor (refer http://m.financialexpress.com/news/rajan-rbi-steps-to-stabilise-re-temporary-and-reversible/1146747/ as a sample). In fact the RBI as an institution, in its first quarter monetary policy review had gone so far as to suggest that but for currency volatility, the bias would have been to continue to ease monetary policy. Given that the repo rate is RBI’s primary policy tool and hence has a large signaling effect, a hike in this rate has been justifiably interpreted by the market as a reversal in monetary policy stance. This was bound to increase term premium on the curve as has in fact been the case.
2. Since the liquidity steps announced mid-July, the participation of PSU banks in the government bond market has drastically reduced. This category is traditionally the largest participant in the market. Subdued participation from this category has resulted in weak appetite for bonds. This in turn is reflected in narrow secondary market volume, lack of appetite in auctions, and widening illiquidity and term premia for all bonds apart from the 10 year benchmark. The lack of appetite from PSU banks in turn is presumably owing to 2 reasons:
a. Average overnight cost of funds has spiked thus rendering government bonds a ‘negative carry’ asset. Besides, as corporate and money markets have virtually frozen, banks have witnessed a rise in working capital draw-down by clients. Because of these reasons, the incentive to buy government bonds has drastically reduced.
b. The sudden jump in yields after mid-July has caused a sea of pain to investment books of banks. Even after the transfer to HTM allowed by RBI, banks will still be nursing substantial residual losses. Hence, there is not much incentive to take on meaningful fresh positions in their marked-to-market books till there is a clear direction to the market.
We must emphasize that our intent in this particular communication is not to question RBI’s repo move. This was brought about, in their assessment, by the need to signal continued discomfort with still high inflation. However, whatever the assessment, it seems clear that RBI has yet again sent a signal that it is uncomfortable with an excessive rise in long end yields. Market has every right to feel confused given that on the one hand the central bank has hiked repo rate and on the other it seems intent on blocking transmission of this signal beyond a point.
From a portfolio perspective our take-away would be as follows:
Post the repo rate hike our view was that yields may become volatile as market grapples with uncertainty in the face of bond supply. This has indeed been the case since the policy. With this statement of intent from the RBI, markets may calm down somewhat. However, the problem of absorbing weekly supply may continue till either PSU banks come back to the market more substantially (possible after HTM transfer and start of new quarter) or the central bank follows through with its statement of intent and starts doing OMOs. Over the medium term, we remain positive on the market subject to the government’s fiscal math falling in place. An additional point to note is that with the Fed taper debate beginning, volatility in financial markets across the globe has risen. This is likely to continue so long as the debate remains unresolved. The same volatility is likely to continue to manifest in our own markets as well. Hence , while medium term pay-offs from bond funds may remain intact, investors should brace for more volatility than before in the interim. This fact should guide matching risk appetite and investment horizon to fund selection.
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