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Losing Steam

The longest bull run in the bond markets is finally faces a roadblock - with falling yields and reduced liquidity.

The long bull-run in bond markets is finally facing serious roadblocks. A string of negative events this week dragged bond prices down with the 10-year benchmark yield rising to 9.16 per cent. The rupee plunged to 47.27 against dollar with falling FII investments, fears of tightening liquidity added to the market's discomfiture. Call rates galloped to touch 7.5 per cent on Friday as banks rushed to cover positions at the end of the fortnightly reporting cycle.

The week started on a positive note with the RBI governor reaffirming the central bank's bias for softer interest rates. The statement boosted sentiments in the money market, then reeling under the impact of aggressive open-market operations (OMO) in the previous week. The three rounds of OMOs had mopped up over Rs 10,000 crore. However, the bull fervour was dented with the announcement of twin auction for Rs 7,000 crore including a 25-year paper for Rs 2,000 crore. The liquidity concerns ensured that RBI did not receive any repo bids for three consecutive days. To add to the gloom, IMF cut its forecasts for India's GDP growth in 2001 to 4.5 per cent from an earlier estimate of 5.6 per cent and against RBI's target of 6-6.5 per cent.

There were more jitters in store with the rupee touching an all-time low in panic trades. The government added to the prevailing uncertainty with contradictory statements on the future direction of interest rates. While the finance ministry is reportedly in favour of a further cut in interest rates, the RBI is aiming at alternative measures to revive growth with interest rates at their lowest level.

Rupee's Fall - Cause for Concern? A sudden drop in the domestic currency sent shock waves and the direction remains unpredictable. Most dealers expect the rupee to weaken further -- between 47.25 and 47.30 levels, before gaining stability. With forex reserves around $45 billion, the RBI has sufficient cushion if it wants to prop up the rupee. On the other hand, the sentiment could remain edgy if FIIs continue to sell stocks and repatriate. FII investments in domestic bonds and equities have been reduced to a trickle - slipping from over $900 million in January this year to a mere $106 million in August. Worse, FIIs have been net sellers so far in the current month, offloading investments worth $50 million.

Outlook
The markets could be in for volatile times and an upside from current levels looks unlikely in the short-term. Since Monday's auction coincides with the start of the reporting fortnight, call rates could firm up. And the advance tax outflows of around Rs 7,000-8,000 crore will also strain liquidity. The rupee's movement will also guide sentiment and any fresh decline could trigger a fresh bout of selling pressure. The RBI is selling a 25-year bond for the first time and its success is crucial to elongate the maturity of government's borrowing programme.

The government is seemingly getting its act together to tide over the current slowdown. A follow up action will boost confidence. FDI investments have already come under cloud with no end to the Enron controversy and four foreign players including Enron have exited the power sector. Thus, a fresh impetus to reforms will not only attract fresh FDI inflows; it will also perk up the equity markets, which have been one of the worst regional performers in 2001.