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Bond markets slip into panic zone

With war clouds looming large, sentiment is likely to remain subdued. However, the yields are attractive for the brave souls. Any takers?

The steady bond markets resemble a panic zone in less than a fortnight. Suddenly, bond bulls have gone into a hiding, volumes have nose-dived and plunging yields have taken a sharp U-turn. The rupee closed below the key 48 mark for the first time and has lost 2.8% since the start of 2001 with the bulk of depreciation coming in September.

The current week started on a jarring note as uncertainty over America's retaliation continued to haunt markets. While the rupee plunged to an all-time low of 48.43, the yield on the 10-year benchmark (2011, 11.50%) touched an intra-day high of 10.05 per cent. However, with the situation spiraling out of control, the RBI finally boosted sentiment by stepping in with dollar sales through nationalised banks. The domestic currency finally ended the day at 47.85. Bond prices also recovered with RBI's decision to buyback select sovereign bonds coupled with a 50 basis points rate cut in the US.

While the rupee saw a gradual depreciation after Monday's intervention, bond markets continue to gyrate. For instance, the yield on the 10-year paper dropped to 9.33 per cent before firming up to 9.70 per cent on Friday. The volumes dropped dramatically with worries over the impact of a possible military conflict between the United States and Afghanistan. Prices were also hit as liquidity tightened with advanced tax outflow of around Rs 8,000 crore. The outflow impacted call rates, which touched a high of 14 per cent on reporting Friday. However, call rates ended the week around 7.10 per cent with the RBI pumping in over Rs 1400 crore through reverse repo auctions.

Wither Interest Rates?
With central banks again cutting interest rates to stave off a recession, expectation is building up that RBI would take a similar step. There is bound to be pressure from the banking industry, which has suffered huge mark-to-market losses on its gilt investments in the current meltdown. However, it is unlikely that RBI would join the bandwagon in haste before fully assessing the impact of any confrontation in the troubled region. With markets volatile, any rate cut can create arbitrage opportunities and trigger a run on the rupee. The central bank has precedence here - it was forced to hike interest rates in July 2000 after a rate cut early in the year when the rupee came under speculative attack. Further, in case oil prices see a sharp and sustained rise, it will create inflationary pressure.

Thus, RBI may continue to provide liquidity by other means. For instance, it bought back bonds worth Rs 4,000 crore during the week at above market price to boost confidence. On Friday, the 10-year paper was purchased at a yield of 9.40 per cent against the prevailing market yield of 9.70 per cent. Clearly, RBI is the biggest and probably the only bull in this market. The apex bank also continues to state its bias for soft interest rates. Further, it is very much likely that the government opts for private placement with RBI instead of an auction till sentiment revives on Bond Street.

Outlook
With the Taleban regime unrelenting, a war now seems imminent. Thus, the markets are likely to remain lacklustre in the near future with the sentiment guided by events in the battlefield. While RBI is attempting to pep up spirits, uncertainty and fear has driven most players on the sidelines. Further, with FIIs pressing heavy sales in equities, demand for dollars is likely to keep rupee under pressure.

The economy is already in the throes of a slowdown with few estimates now putting GDP growth under 5 per cent. Thus, the current crisis has come at the most unfavourable juncture where the country cannot afford any external shocks. With a falling rupee, an oil shock will be a double whammy and a burgeoning energy bill could further hit a precariously poised deficit. The tax collection estimates are also likely to go haywire. Thus, a larger than expected government borrowing programme is likely to put interest rates under pressure.

Among the positives, yields are now attractive with participants sitting on large cash positions. Hence, an early end to the crisis will see prices bounce right back. The spread between top quality corporate bonds and government securities has also gone up to 140 basis points, making the former an attractive investment. Any takers?