SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS

VICIOUS SELL-OFF IN INDIAN BONDS

The 10-year Government security yield rose from 5.25% on January 1, 2009 to close the week at 6.25%. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index rose 87bp from 8.11% on December 30, 2008. The 5-year OIS rates ascended to 4.94% from an all time low of 4.42% on January 2, 2009.

Real GDP growth will remain below trend not only in 2009 but also in 2010. Inflation will likely recede below 5%. Global central banks will maintain an easing bias in 2009. Given this backdrop, the Reserve Bank will cut the reverse repo rate by at least 50bp in the next 6-months. I view this sell-off as an opportunity. Risk free yields will decline, the curve will flatten and AAA corporate spreads will shrink significantly from current levels.

GLOBAL MONETARY CONVERGENCE CONTINUES: RISK IS OVER EASING TO COUNTERACT DYSFUNCTIONAL TRANSMISSION MECHANISM

The Bank of England reduced base rates by 50bp to 1.5% last week, the lowest level since 1694. Easing inflationary concerns imply that the ECB will follow suit sooner rather than later. The Fed’s minutes revealed a discussion on quantitative targets for preventing “deflationary dynamics”. The Bank of Korea slashed policy rates to 2.5%. Indonesia and Taiwan also cut by 50bp. Bottom-line, while there are signs that credit markets are unfreezing, big questions remain about the percolation of base liquidity into the broader economy. In all probability, monetary authorities will risk overshooting on the downside to counteract tighter lending standards and high spreads.

PERSISTENT EXCESS LIQUIDITY TO AID BONDS IN THE FACE OF A LARGE GOVERNMENT BORROWING PROGRAM

I predict consistently high reverse repo quantum in the foreseeable future. Please refer to my piece - LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN; December 14, 2008 - for details. The end-game will be a rising investment to deposit ratio. Despite rising issuance, slumping private investment demand will create space for government bonds in public sector bank balance-sheets.

10-YEAR GOVERNMENT BOND YIELD TO TRADE BELOW 5% EVEN WITHOUT FURTHER MONETARY EASING

In a scenario where the reverse repo rate remains at 4.0%, 1-year YTM (4.63% on January 9, 2009) will trade close to 4.10%. Low yields and large cash chests will lead to a chase for yield, resulting in shrinking term and credit spreads. The 1/10 spread closed Friday at 162bp and averaged 85bp since 2001. Based on data since 2001, the mean 1/10 spread measured slightly below 85bp when the 1-year yield-to-maturity set below 5.50% on average. These numbers emanate largely from 2002 and H1 2003 - a period characterized by economic circumstances not very different from the current reality. Thus, even without a rate cut I see the 10-year Government security yield falling below 5.00% in H1 2009. Most likely, there will be further cuts and 5.00% should be conclusively broken.

1-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 1/10 SPREAD

1YEAR YIELD***********1/10 Spread
4.00%-4.50%***********74bp
4.50%-5.00%***********77bp
5.00%-5.50%***********82bp
5.50%-6.00%***********111bp
6.00%-6.50%***********98bp
6.50%-7.00%***********99bp
7.00%-7.50%***********98bp
7.50%-8.00%***********38bp
8.00%-8.50%***********84bp
8.50%-9.00%***********89bp
9.00%-9.50%***********25bp
9.50%-10.00%***********91bp

HIGH QUALITY CORPORATE PAPER WILL OUTPERFORM TREASURIES IN 2009

The average yield on the FIMDA Bloomberg 10-year AAA corporate bond index averaged 106bp above 10-year Indian treasuries since December 2001. The current 10-year AAA corporate spread rests 2.4 sigma above the mean observed over the last 7-years. There is a high positive correlation between spreads (even in percentage terms) and the level of the yield curve measured by 10-year Government security yields. Bottom-line, the incremental return over treasuries will collapse significantly by the end of 2009.

10-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 10-YEAR AAA CORPORATE SPREAD

10YEAR YIELD***********AAA Spread
5.00%-6.00%************67bp
6.00%-7.00%************65bp
7.00%-8.00%************128bp
8.00%-9.00%************167bp
9.00%-10.00%***********154bp

TACTICALLY I AM SHIFTING MY ASSET ALLOCATION AWAY FROM EQUITIES TO BONDS

I view the current sell-off as an opportunity to build further long bond positions. The risk-reward from current yield and spread levels appears good. Also, I am reducing my equity index positions in light of continued bad economic news and possible downside surprises in the earnings season.

Bloomberg is the source for all the data used.