Bond Market Insight-Government bond auction results: market keeps rates at acceptable levels

In yesterday\\\\\\\'s government bond auction, the MoF managed to raise nearly UAH1bn, further lowering the yield curve, particularly its short-term segment (i.e., with duration of up to one year). A 9-month T-bill maturing in February 2011 was placed at 9.42% YTM, down 54 basis points from the 9.96% yield which a similar bond was placed at a week ago. Another instance of yield retrenchment was seen in another T-bill due in May 2011; two weeks ago, its yield was 11.50% YTM, and yesterday, this was lowered by 45bp to 11.04% YTM. At the far end of the yield curve, where a Euro-2012 bond has been placed at recent auctions, a yield of 12.93% was again fixed, with no change to previous placements of the bond. In our view, such a yield curve compression, particularly at its short end, allows the market participants to enjoy reasonable yields for instruments with duration of up to one year. Naturally, the local financial market expects the launch of the expectedly high-yielding VAT bond issue, which, as MoF officials said, is to appear in late July or early August, which is why the high liquidity in the banking sector (as measured by the volume of funds at banks\\\\\\\' accounts with the central bank amounting to UAH32bn, nearly double the level seen in early June) is not spilling over into the local bond market (i.e., rates did not go down sizably), let alone into the local credit market. The banks, with such additional liquidity, have few incentives to place their spare funds in the central bank\\\'s short-term CDs, which provide lower rates than the T-bills with comparative tenors.

Aside from the VAT bond issue, this combination of factors should have pushed yields lower on the government bond market. Meanwhile, another factor is playing out in favor of stronger prices for local government bonds: a trend of monthly deflation seen during last three months (from April to June). If this extends into the remaining months of the summer, then authorities will likely be alarmed regarding weakening demand, which results in headline inflation slowing too fast in YoY terms (6.9% YoY in June, heading to the low single-digit area as of year-end if monthly CPI stays close to zero). Then, authorities may worry regarding nominal growth of the economy, which could be quite low, and together with the expected rise in net borrowings, would translate into a weaker (and hence riskier) profile of the economy. Ultimately, the central bank is likely to construct another rate cut in order to spur demand to prevent a deflationary trend from taking root in the economy and instead keep inflation at a moderate level (e.g., in the 7-9% range).