Are short-term Indian bonds too cheap?

Are short-term Indian bonds too cheap?

Mumbai: Are Indian short-term bonds too cheap, given the prospects that a rapid economic recovery may lead to quick interest rate rises?

Or will the weak monsoon trip up growth and keep policy rates low for a long time?

India’s bond curve has been flattening with the shorter-end moving up as investors price in an economic recovery, but with disappointing rainfall threatening the agriculture-dominant economy, some market participants worry that money markets may have gotten ahead of themselves.

The 3-month treasury bill yield has climbed 25 basis points since the start of July to 3.36% in the previous auction, while curve spreads between 1-year and 10-year bonds have narrowed to 250 basis points from a record wide 326 basis points on July 24.

Some analysts expect that term spread to narrow to 200-240 basis points in a month.

Spreads between 1-year, 5-year swaps have tightened to 191 basis points from near 217 in early July.

At a review last month, the Reserve Bank of India (RBI) kept its policy rates steady after cutting them by a record 425 basis points since October and said growth in the 2009/10 fiscal year is expected at 6 percent, with the risk on the upside.


Recommendations to sell short-term bills, therefore positioning for a bear flattening of the curve, are based on expectations the central bank will start tightening policy soon, but longer-term rates would rise less quickly as inflationary expectations are still subdued.

Official data showed factory output expanded at its fastest pace in 16 months in June. A 31% rise in car sales in July indicated the positive momentum might be sustained.

“Rate hikes are not seen immediately but may happen in another six months time or so ... it’s not that far away now," said Vineet Malik, head of interest rates at HSBC India.

The Reserve Bank of India raised its inflation target for the year end to 5% by end-March 2010 from 4% earlier.

Analysts at Goldman Sachs expect policy rates to be tightened by 300 basis points in 2010.

“With growth and inflation expected to be higher, the ‘exit´ policy from an extremely loose policy would entail in our view, tightening via currency, rate hikes, liquidity absorption, and a gradual removal of fiscal stimulus, in that order," they said.

Expectations are that the central bank’s first move would be to start withdrawing the more than Rs1,100 crore ($22.8 billion) in excess cash from the money markets, and swap rates have already started pricing in tighter money market rates ahead.

K Ramkumar, head of fixed-income at Sundaram BNP Paribas Mutual fund, forecasts the 91-day t-bill will rise to 3.50% in the next month.

With appetite for longer-dated paper falling as inflationary pressures start building, policymakers are issuing more shorter-dated paper to complete the borrowing plan.

In addition, the government has said it will start selling cash management bills which will carry a maturity of less than 91 days, which is currently the minimum tenor of money market instruments in India.

All these measures are telling on the front end of the curve.

“It seems the RBI would go all out to arrest the spike in the longer tenor yields and access shorter tenor funds for the government till things are back to normal," said J. Moses Harding, head of global markets at IndusInd Bank in Mumbai.


But with India’s economic revival facing headwinds from a weak monsoon and question marks over the timing and strength of a global recovery, bond dealers said tightening expectations may be premature.

Between the start of the summer monsoon season on 1 June and Wednesday, rainfall was 29% below normal. Deficient rainfall usually hurts rural demand.

“The shortage of rain is likely to keep regulators focused to the easy monetary stance for a longer duration than expected earlier, and rates may not harden much on both ends," said Sanjay Arya, deputy general manager, treasury at Bank of Maharashtra.“