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Unscathed Yields

Owing to the increase in cash reserve ratio, bond prices took a beating, but the buoyancy in liquidity ensured that they recovered lost ground

The much awaited policy review had its bag of surprises. The biggest one was the upward revision in the cash reserve ratio (CRR), now stands at 7 per cent - the highest since November 2001. The saving grace was that the RBI kept other key interest rates unchanged and as expected removed Rs 3000 crore daily cap on its money market operations. The severity of RBI's backlash did take the market by surprise. But given the correction over the previous week it was not surprising that the market managed to contain its losses.

A day before the policy review, (Monday, July 30) there was enough buying in the market to pull yields down. But by Tuesday the mood had turned sour and the yield on the 10 year benchmark, 7.49 per cent GOI 2017 bond shot up by eight basis points from its previous close. Unlike previous CRR hikes, the fall in bond prices was not as severe as ample liquidity in the market checked the rise of bond yields. Wednesday continued to be depressing, as market participants continued to sell bonds to meet the revised requirements. The situation was also exasperated by the MSS auction on Wednesday.

Fortunately there was some recourse for the market, the heavy selling over Tuesday and Wednesday lead to bargain buying on Thursday. On Friday the market looked to have corrected its course, with the yield on the benchmark paper closing at 7.85 per cent compared to the previous week's close of 7.84 per cent. The trigger for this correction was the lower than expected cut off yield at the government bond auction (on Friday), aided by the ample liquidity before the revised CRR took effect on Saturday. In addition to this reported inflation at 4.36 per cent for the week ended July 21 continued to remain under the 5 per cent comfort zone.

Outlook
The CRR hike along with the removal of restrictions on the daily money market operations will constrain the supply of funds in the bond market. The CRR hike itself will drain out Rs 16000 crore. Near zero call rates have already shown an upward trend. Yet all this has not dented market sentiment. As long as the central bank continues to intervene in the currency market, a liquidity crunch will be kept at bay. However, for the forthcoming week, the combined effect of the revised CRR and the Rs 7500 crore auction on August 8, will ensure that yields remain edgy. Moreover the threat of a revision in domestic fuel prices and a consequent fear of rising inflation is far from over.