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While international commodity prices are moving up; economic recovery at home is also speeding up. Together these are fueling imports and inflation at home. A perception is building that interest rates may inch up a little. The policy rate is becoming irrelevant seeing the recent movement in the secondary markets yields and bond auctions.

The problem in the bond market is that the government is the biggest buyer of bonds; but it doesn’t have many options. The government cannot borrow from SBP under the IMF. There is no international issuance of Euro Bond or Sukuk for one reason or the other. There is dearth of pension and insurance buyers. The fiscal deficit is not in control. All the government can do is to buy from the local market – dominated by a few banks.

The market (mainly banks) knows that the government has to come to them for financing its deficit. They are one up. Then they have an inherit put option. If they don’t lend it to the government, SBP will mop up the excess liquidity at the floor of the corridor. Banks are hedged. Government lacks options. That results in banks driving the market and rates.

The Debt Office at Ministry of Finance was of the view that interest rates should remain low, and wanted to sell bonds at low rates. In July 2020, market was of the view that interest rates will remain at current rates. Market and debt office were on the same page. The cut-off yields of bonds were 7.37 percent for 3Y, 8.37 percent for 5Y and 8.99 percent for 10Y. These were in line with the policy rate at 7 percent. At that point, some corners were saying that interest rates may come down further.

Then came the economic recovery which surprised many. The market started thinking that the rates are bottomed out and sooner or later they will move up. They started bidding at higher rates. But the debt office was not convinced and was probably perceiving that inflation would be tamed and rates will remain stable.

The cat and mouse game between the government and banks treasuries continued from August to December. Government started scraping 5Y and 10Y papers. Seeing this, the market stopped (or lowered) participation. However, inflation did not come down as was expected by ministry. And recent global commodity prices upward movement, probable electricity prices adjustment and possible coming back of the IMF are making debt office to rethink.

In the latest auction in January, the debt office has shown its new strategy. The auction is not scrapped, though participation was minimal by the market. Debt office has accepted some amount to reveal its new acceptance levels. The cut-off yield of both 5Y and 10Y papers increased by one percentage point to 9.53 percent and 9.99 percent from last accepted auction. Now the cut-off rates are matching the secondary market yields.

This implies that debt office is thinking of one percent increase in a few months. The assertion is not out of bound. The real interest rates are close to negative—2 percent based on FY21 inflation estimates. Last year, it was positive 2 percent. It should be somewhere in the middle. In July 2019, it wasn’t the best decision to take rates up to 13.25 percent and similarly bringing down to 7 percent was not a great idea either.

Volatility is the killer. Market gets the chance to manipulate the government. The SBP should try to keep real rates close to zero. There might be some increase in rates in May or July. The rates in the next 12-24 months are likely to hover between 7-9 percent. A 1 percentage point increase to 8 percent by May or July won’t surprise many.

Banks’ treasury offices need to take note of this. They should not be greedy anymore as 9.99 percent on 10Y and 9.53 percent in 5Y are good rates. They should participate higher amounts on this. Debt office should accept higher amounts, if banks bid on these rates.