Policy, inflation doubts halt Indonesia bonds rally

SINGAPORE Aug 6 (Reuters) - Indonesian government bonds appear to have run into some resistance after a surprising rally that lasted nearly two months and occurred despite rising policy rates and accelerating inflation.

Bond prices at the longer end of the yield curve had risen since June, boosted by the abundance of cash in the banking system and strong belief that, unlike in 2005, the authorities had a firm grip on inflationary pressures and policy.

Five-year bond yields hit 10.9 percent on Wednesday, down from 13.4 percent in early June, as bond prices soared.

But the steepness of the rally and persistent inflation have sowed some doubts in investors' minds, and put a floor under yields. At least a couple of analysts had been expecting 5-year yields to hit 11 percent only by the year end.

"People have been buying into Indonesia on the expectation that this inflation shock, similarly to Korea, will work its way through the system and pop out the other side. That inflation will come off," says Peter Redward, head of Asian rates strategy at Barclays Bank.

"We are pretty sceptical of that view in Indonesia," he said.

Redward reckons that strong economic and credit growth will exert upward pressure on inflation for longer. Moreover, the full impact of the surge in global commodity prices had not yet been passed on to Indonesian consumers.

Even those who are bullish Indonesian bonds doubt five-year yields could fall far below 11 percent.

The Southeast Asian economy has been less affected by the wider credit crisis than its neighbours. The economy expanded 6 percent in the April-June quarter from a year earlier, credit growth was more than 30 percent in June and non-oil imports are increasing at a near 50 percent pace.

Consumer prices rose 11.9 percent in July from a year earlier, the biggest annual rise in almost two years.

Other elements of the inflation picture appear supportive of bonds. The monthly pace of price rises moderated to 1.4 percent in July, nearly half June's pace, as the effect of May's rise in the price of Indonesia's highly subsidised fuel wore off.

Imported oil is also less dear, with prices now at $118 a barrel, 20 percent down from their peaks a month ago.

"Indonesia is a very high beta trade on oil," said JPMorgan's Siddharth Mathur. "As long as oil behaves itself, people will start to price out the riskiness of Indonesian bond market and therefore you will get a rally."

FLATTER CURVE

The country imports crude oil, and its subsidies are among the highest in Asia. With parliamentary and presidential elections looming next year, analysts suspect the authorities will be quick to cut fuel costs, if import costs drop.

Still, until investors are sure food and transport costs are firmly on their way down, bets on further bond rallies are off.

If global oil stabilises around $120 a barrel, Indonesian 5-year bond yields would stay near 11 percent, Mathur says.

Besides, the central bank hasn't quite finished tightening policy, even after four rate rises in as many meetings. After raising rates on Tuesday, Bank Indonesia said inflationary pressures persisted and it would use all means to fight them.

Speculation that it will raise compulsory reserves that banks have to maintain and allow banks to hold bonds under such reserves have also boosted longer-term bonds.

A one-month treasury bill rate of 9.23 percent, compared with the current 9.0 percent policy rate, indicates the central bank could raise rates one more time. One-year yields climbed to 9.55 percent on Wednesday from 9 percent on Tuesday.

The drop in long-term yields and the more recent rise in near-term yields has flattened the curve. The spread between one and 20-year bonds is 250 basis points, down from 370 a week ago.

Economists think it might get even flatter as the central bank tries to slow down domestic demand and credit growth.

Longer-term yields are anchored by expectations inflation won't spiral out of control like it did in 2005.

"It's not a shock, it's an orderly rise in interest rates," said Morgan Stanley economist Chetan Ahya.

"So the shock premium is being wiped out but I don't think the short end is done yet. They need to tighten more to ensure they don't have a disruptive move later on." (Editing by Neil Fullick)