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Rally Survives on Ample Liquidity

The market continues to expect a bank rate cut despite contrary indications from RBI officials.

A cautious market survived a plateful of scares this week. A plummeting rupee, US-64 fiasco and finance minister's statement threatened to derail the rally in the bond markets. Yet, ample liquidity in the system coupled with a persistent hope for rate cut ensured that bond prices continue to move up. The market continues to expect a reduction in bank rate despite indications on the contrary from RBI officials.

The finance minister fired the first salvo on an edgy bond market when he hinted at higher government expenditure to boost the economy. This pulled down bond prices since a fiscal stimulus means increased borrowing from the market. Although RBI governor's statement that the borrowing would be within targeted limits assuaged sentiments, it is baffling how the government can afford to stay on track while boosting its spending. While revenue collection is on a decline in the face of a slowdown, there is hardly any activity on the much-talked divestment front as well. The RBI has borrowed briskly so far in the current fiscal, raising a gross amount of over Rs 64,000 crore in just three months. If the government overshoots the targeted borrowing of Rs 1.19 lakh crore, it would create a supply overhang in the system and put pressure on bond yields.

Apart from the flurry of government speak, a sharp fall in the rupee added to the discomfort of the market. The domestic currency, which lost 10 paise to hit Rs 47.15, sank further to Rs 47.21 on Tuesday as dollar demand outstripped supply. However, the rupee recovered on fresh supply of the greenback and traded around 47.13 levels for the week. Despite the fall, rupee continues to be overvalued and could further see a "controlled" depreciation in the coming weeks.

After firming up on the first day of the reporting fortnight, call rates remained in the 6.5-7% band on the back of easy liquidity. Call rates were also initially under pressure due to twin auction in the previous week. With a soft call, the RBI attracted huge bids for its one-day repo auction with the cumulative amount at Rs 21,180 crore while the 3-day auction on Friday saw an outflow of Rs 11,800 crore. The week saw another twin auction for Rs 7,000 crore at the longer-end of the segment, including a rare sale of 20-year paper. With this, the RBI has completed 54% of the borrowing programme.

Outlook
A surfeit of liquidity has assured that bonds continue to move up though there are no obvious positives for the market. Thus, despite RBI ruling out an immediate rate cut, prices have been on the rise after a few rounds of temporary correction. It seems that the government is now looking at a mix of fiscal and monetary steps to shore up the growth rate. With ample liquidity in the system pulling down yields, RBI may prefer to continue borrowing at current levels, opting for a rate cut only if money supply comes under pressure. If a rate cut does not come in the immediate future, the market could see a longer and a steeper fall. This does not augur well for the players, especially banks, which are carrying huge investments made in longer-dated gilts this year.