Nomura expects underperformance of the 9 year-15 year zone of the bond curve to reverse and swap curve flattening to persist
Interest rates continue to move lower across the yield curve of various rates products (from bonds to swaps), reinforcing the strategic bullish view on India rates, opines brokerage firm Nomura. In fact, it believes bond markets are facing the typical bull market questions of selection rather than participation: not whether to buy, but rather which bonds to buy. “In markets like these it is important to discuss the factors that impact the outperformance of one part of the yield curve versus another, as we believe capturing yield curve dynamics will generate the alpha for investors,” said Nomura.
The brokerage takes a look at the factors that it believe will lead to a reversal of the underperformance of the 9 year-15 year part of the bond yield curve in the next month or two. Assuming repetitive assertion is an important part of a strategists’ job, it notes that on the swap curve, flatteners continue to make sense and remain our preferred trade to express the nature of the current economic cycle.
Fly depicting 9yr-15-yr underperformance
9 year-15 year underperformance on the bond curve to reverse over the next two months
The current price action in rates markets continues to reinforce the strategic bullish view on India rates. However, simply being bullish is too simplistic, says Nomura, while discussing which part of the yield curve will outperform, following the recent theme of yield curve dynamics generating alpha for investors.
Over the last few months, Nomura has argued that the outperformance of the 3year-5year sector of the India bond yield curve. In line with its expectations, this part of the yield curve has outperformed, with the 5s10s spread moving from -2bp to 20bp by the end of last week. 5s30s also moved from 15bp in mid-January to 30bp, with some flattening last week. This outperformance in the 5year sector is primarily due to technical reasons such as supply differential, liquidity dynamics and positioning dynamics. April saw supply with no Reserve Bank of India (RBI) open market operations (OMOs), as liquidity conditions were reasonably comfortable due to government spending. The RBI has also carried out three consecutive rate cuts since January, which impacted the front end of the curve more than the backend.
However, according to Nomura, the impact of these technical reasons is already priced into the market and some of these reasons should reverse from here on. The brokerage believes the announcement on the amount and timing of OMOs will be an important driver of bond markets. Also, Nomura does not expect the RBI to cut rates in June, hence front-end outperformance should take a pause for the next month or two. It believes that the new 10 year benchmark, which will be issued this week, will only have a marginally positive impact on surrounding bonds. The new 10 year benchmark will likely come at around a 12-15bp premium to the current benchmark. However, once issued, one can expect spread compression between the older benchmark and the newer benchmark, as the older benchmark remains the candidate for OMOs with no further supply, stated Nomura.
As far as secondary-market liquidity is concerned, the current benchmark should remain more liquid than the newer benchmark, at least until July—it will take a couple of months before the newer benchmark reaches a reasonable outstanding amount of Rs250 billion. All in all, there are strong reasons for 9 year-15 year benchmark underperformance to reverse over the next month or two, according to Nomura. However, on a three to six–month horizon, it believes the 3 year-5 year part of yield curve will remain a sweet spot, and therefore remain very comfortable with its current long 5 year bond recommendation. Nomura continues to target 7.17% (India government bond 8.07 2017; Initial Entry 8.17%; Last Entry 7.82%; Current 7.42%; Target 7.17%).
Current liquidity conditions and OMO expectations
According to Nomura’s estimates, the total system liquidity deficit (banking system liquidity deficit + government cash surplus) is approximately Rs650 billion, with an estimate of the government cash surplus at approximately Rs300 billion as of 3 May. The brokerage believes the RBI will conduct another Rs400 billion-Rs500 billion of OMOs to keep banking system liquidity conditions relatively comfortable. Overall, it expects Rs1.2-1.4 trillion of OMOs this fiscal year.
In swaps, flatteners remain our high conviction trade
In swaps, flatteners remain a favourite high conviction trade for Nomura. Its view of swap flatteners is primarily dependent on the assumptions that: 1) the RBI will continue to be reluctant in its approach toward monetary easing, which is evident from its cautious guidance despite delivering a 25bp repo rate cut at its May policy meeting; 2) liquidity will remain in deficit; and 3) the low-growth environment means receive pressure in the belly of the swap curve should be maintained.
On liquidity, Nomura’s models suggest that banking system liquidity will continue to remain in deficit, at least over the next two to three months. Liquidity deficit conditions should also keep MIBOR fixings elevated, averaging 5-10bp over the repo rate. OMOs are another reason encouraging a receive bias in the belly (3 year-5 year) of the swap curve. Overall, it remains reasonably comfortable with its swap flattener view and continues to see value in recommending 1s3s swap flatteners (Last Entry in Feb -31bp, Current levels including carry-roll: -58 bp, Target -60bp). “Even as we are fast approaching our target of -60bp, we see value in holding to our flattener view and do not see a compelling need to take profit even after hitting our target,” says Nomura.
Swap curve flatteners (spot and forward space)