Views: Exit long play neutra

Ahead of the policy, we prefer to cut our long positions in 5Y bonds and less bullish on the 2y bonds that have moved more than 30bp and 50bp respectively since the initiation.

While we believe that this may not be bottom of the yields and there may be more juice left , but due to the yield levels and recent developments we believe that risk/reward favors a more neutral stance. The reasons are:

1. RBI conducting twist against OMO

Main determinant for yield movement currently is demand/supply dynamics, which again is guided by RBI - the biggest buyer. RBI in the past two GSEC OMOs has preferred to conduct only Rs. 10k cr. size instead of INR 20K crs - and that too as a twist than outright buy (more on this later). Of course this has been substituted by an increased tactical secondary buying, but not large enough to fill the gap. Also, it did not come with OMO this week. Whilst it hadn’t announced OMO in last policy too, but during that time (i) OMO were intermittent, and (ii) RBI had not formally announced a INR 20K crs OMO. Thus (i) either RBI is comfortable with yields, or/and (ii) RBI wants to minimize monetization. Either of the option does not give enough confidence that yields would be pushed lower due to RBI purchases.

2. Macro-economics

While macro parameters are not the guiding force currently, they are becoming more relevant - especially with global yields moving higher. The growth reversal is sharp, and initial expectations may have been too pessimistic. Inflation has been sticky, and as growth rebounds the core inflation may rise - with Brent adding more pressure. While supply/demand may be important now, but whenever the yield reversal takes place it will most probably be driven by the macro scenario - and that scenario seems closer now than ever before.

3. Surplus liquidity

The short-term yield levels have also been impacted by the overnight TREPS rate (@ 2.70%) - influenced by liquidity. The liquidity surplus levels seem unintended - driven largely by FX. The same can be observed when RBI prefers twist instead of outright OMO for liquidity neutral bond intervention. Thus if it is unintended, it is clear that sooner or later RBI would try to reverse/arrest the same. This would put pressure on the shorter tenor bonds in particular.

4. Monetary Policy

It is unlikely that Monetary policy will be significantly different than last policy as the central bank may prefer consistency. However it is quite likely that the events of last two months (better growth outlook, higher inflation, better global outlook, higher Brent etc.) would find resonance with the MPC members. Thus the lopsided risk is that MPC may surprise on being less dovish than expected.

On the face of above points, we prefer to be neutral (from long position) on 5Y bonds as the reasons for the trade are less compelling now. While we believe that the yields have space to go lower, but this trade is a crowded trade and we would prefer to be more cautious lest we get caught at the wrong side.

Preferred trades

We prefer to pay the 5Y OIS. However there is a significant carry loss in the swap, and thus would prefer to build the position gradually especially since we do not foresee it running away in a hurry. We continue to believe that OIS would trade in narrow range and 4.35-4.55 should remain intact – barring noise breaches.

We would be on lookout to play tactical long trades on the underperforming yield points, though we do not observe such trades currently. Since RBI is ensuring that the bond markets remain stable, we believe that any underperforming/stressed point would sooner or later revert to normal. We saw the same happening to 5Y point earlier, and see no reason to believe it won’t happen in future.