Sri Lanka gilt yield curve flattens amid currency pressure

ECONOMYNEXT - Sri Lanka's longer term bond yields remained subdued while short tenors spiked in October as a rate cut and liquidity spikes pressured a soft-peg with the US dollar forcing authorities to stop pushing down the short end of the yield curve to protect the currency.

There is strong demand for medium to longer term bonds at around 12.00 to 12.25 percent, dealers say.

Sri Lanka has high nominal interest rates are common in countries with permanent currency depreciation.

Permanent depreciation generates perceptions of a weak currency that foreign investors factor in, while domestic market participants also panic because the currency does not usually bounce back which generates runs and rate spikes.

When currencies fall, inflation tends to go up from the traded sector (exports and imports) even if domestic credit is weak and non-traded price rises are muted, analysts say.

On Friday bond yields spiked and fell back. Dealers said there was also foreign investor interest.

On Monday a 3-year bond maturing on 15.10.2021 was quoted at 11.30/50 percent, down from Friday's peak of 11.90 percent.

A 5-year bond maturing on 15.07.2023 was quoted at 11.65/75 percent, down from Friday's peak of 12.05 percent.

The risk free yield curve is now flatter than at the beginning of the year, amid perceptions that the current high interest rates are due to currency pressure, which may ease.

Authorities allowed unsterilized excess liquidity to build up twice in 2018, despite rising US rates, causing short term rates to fall, but did not consistently follow through with unsterilized sales. A sharp switch to a floating style regime with excess liquidity intact, has generated runs on the currency.

Low short term rates encourage market participants, such as exporters to borrow domestically and delay conversion, and importers to borrow and settle bills quickly, worsening pressure on the currency. Swap rates are also against the rupee during those times.

However monetary policy has been broadly supportive of the rupee for almost three weeks, with liquidity short in money markets, and rates gradually adjusting. Sri Lanka has a ceiling policy rate of 8.50 percent, which is over three times that of the US.

If pressure on the currency eases, interest rates will gradually fall.

The flattening of the yield curve was also seen at a bond auction last week.

An offer of 20 billion rupees of 2033 bonds was snapped up at an average yield of 11.90 percent, at a cut-off around 12.0 percent with bids of 55 billion rupees coming in.

But a 20 billion rupee auction of 5-year 2023 bonds drew bids of 48.6 billion rupees, and the central bank forced on dealers at an average yield of 11.69 percent under a coercive bond sale scheme after bids came in close to the longer tenor.

The forced purchase may have come because of a mis-understanding on the development of the yield curve or the usually prevalent bureaucratic coercive mindset that has brought instability to the country in the past, according to market participants.

However a flattening of the yield curve also shows improved debt managed compared to 2015 and 2016.

In the so-called bondscam years, long tenor bonds were issued in excess of the volume that long term buyers could absorb amid allegations of corruptions, despite claims that fiscal policy would improve in two years.

If there is short term pressure, a private borrow would try to borrow short tenor or at floating rates and go for fixed tenors when rates are down.

Last week the central bank allowed Treasury bill yields to go up after rejecting offers for two weeks. In countries with sustainable pegs, short term rates fluctuate freely.

There is a sharp bend in the yield curve at around 3-years, with a sharper slope in shorter tenors. Whether this is due to better liquidity, greater ability for primary dealers to raise funds in the repo market with more banks willing trade them, or insufficient issues at the lower end, is not clear.

Analysts have said that the central bank generally pressures the currency and generates full blown balance of payments crises by rejecting bids at the Treasury bill auctions and purchasing them with printed money at non-transparent rates, either to push up excess liquidity or to fill interventions (sterilize forex sales) and keep rates down artificially. (Colombo/Oct15/2018)