50bps rate cut, gsec yields will fall and then rise, 25bps rate cut, gsec yields will rise then fall.
RBI in its policy meet on the 6th and 7th of December 2016 is likely to cut the Repo Rate by 50bps. However, the rate cut could be the last of the rate cuts as that would have factored in CPI inflation of around 4.5% levels for the next fiscal year. RBI rate cut will be due to the downward pressure on inflation and GDP on the back of Demonetisation. The fact that Demonetisation has lowered demand in many sectors of the economy due to cash crunch, growth and prices are likely to come off for the second half of fiscal 2016-17. GDP growth for the second quarter of fiscal 2016-17 came in at 7.3% as against 7.1% growth for the first quarter. RBI growth forecast is 7.6%, which is unlikely to be achieved. RBI rate cut is a balm to the economy feeling the temporary effects of demonetization.
Government bond yields will initially fall sharply on the back of the rate cut but then will start to trend up again as markets will not have any rate cut cues to work with going forward. A 25bps rate cut could disappoint markets and yields could then factor in the disappointment initially but markets will then look forward to another 25bps rate cut and this could drive down yields again.
Bond markets would also have to contend with increased supply of bonds with the government fixing MSS issuance ceiling at Rs 6 trillion. Government issued 28 days CMB (Cash Management Bills) for Rs 200 billion on the 2nd of December, which saw cut off at 6.1557%. MSS securities will be auctioned to suck out liquidity as RBI is running out of Gsecs for reverse repo.
The ten year benchmark bond, the 6.97% 2026 bond saw yields rise by 1bps week on week to close at levels of 6.24%. The old ten year benchmark bond, the 7.59% 2026 bond saw yields rise by 5bps to close at 6.37% levels while the On the Run bonds, the 7.88% 2030 bond and the 8.13% 2045 bond saw yields rise by 5bps and 3bps respectively to close at levels of 6.51% and 6.67%. Gsec yields will take direction from rate cuts.
OIS market saw one year OIS yields close up by 4bps and five year OIS yields close up by 2bps week on week. One year OIS yield closed at 6% while five year OIS yield closed at 6.09%. OIS yield curve will steepen in the coming weeks as markets factor in easy liquidity and rate cuts.
Credit spreads closed mixed last week. Three-year benchmark AAA corporate bond yields rose by 10bps week on week to close at 6.73% levels. Credit spreads rose by 7 bps to close at 62bps levels. Five-year benchmark AAA bond yields rose by 5bps to close at 6.81% with spreads falling by 2bps at 50bps levels. Ten-year benchmark AAA bond yields rose by 10bps to close at 7.06% levels with spreads up by 9bps at 72bps. Credit spreads are likely to go down on rate cuts and high system liquidity.
System liquidity as measured by bids for Repo, Reverse Repo, Term Repo and Term Reverse Repo in the LAF (Liquidity Adjustment Facility) auctions of the RBI and drawdown from Standing Facilities (MSF or Marginal Standing Facility and Export Credit Refinance) was in surplus of Rs 2066 billion as of 2nd December. The surplus was Rs 5153 billion in the week previous to last. Government surplus was Rs 1211 billion last week, up by 1100 billion week on week. Liquidity will continue to surge as banks deposits increase on demonetization.
