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Hunt For Trigger Continues….

A turbulent week for government bonds. The yield on the 10-year benchmark (11.03%, 2012) touched a low of 7.20 percent during the week to close at 7.60 percent. Yield rose after the 50-basis points cut in repo rate by Reserve Bank. Bonds will remain weak, given not so strong market dynamics (read tight liquidity).

The week was turbulent for the government bonds. The yield on the 10-year benchmark (11.03%, 2012) touched a low of 7.20 percent during the week to close at 7.60 percent. Yield rose after the 50 basis points cut in repo rate by Reserve Bank.

With the reduction in repo rate, the yield on the 91-day Treasury bill fell by 12 basis points to 6.1 percent over the week. After touching 7.10 on the Budget day, call rates too remained firm in the 6.30-6.60 per cent range on the back of abundant liquidity with little demand for funds. The repo rate cut is likely to correct the distorted short-term money market yield curve. The rupee traded steadily against the dollar with supplies from exporters and some foreign fund inflows. However, rupee closed lower 4 paisa at Rs 48.74 as compared to last week.

The small savings rate cut, reduced tax incentive under section 88 and tax on dividend from mutual funds has broadly reduced the charm of fixed income alternative's including insurance vis-à-vis bank deposit. But with declining bond yields and lack of credit off-take, it will be tough for banks to sustain their prevailing deposit rates. Currently, 5-year bank deposit gives an 8.5 per cent return, which is substantially higher than 6.8 per cent return on a 5-year government bond.

But structural rigidities prevail, like high rates on EPF, high NPAs of banks and low spreads. And these are the key impediments to lower interest rate regime. To begin with, RBI has reduced the minimum lending rates by 100 basis points to 12 percent for urban cooperative banks. This will add to their competitiveness vis-à-vis commercial banks. Commercial banks' lending rates range between 9 to 13 percent and determined by banks.

Repo Rate Cut: Implications
The RBI cut the repo rate by 50 bps to 6.0 per cent on Tuesday. This can be a pointer to the bank rate cut. And it is widely anticipated in the forthcoming Monetary Policy, next month. And cut in bank rate could force banks to review their deposit rates. This can also bring down coupon on corporate bond issues. Repo rate generally serves as a floor reference for the call rate. Else, it creates an arbitrage opportunity for banks. Hence, the reduction in repo rate will drag the returns of cash funds, which actively participate in the call money market.

Outlook
Bonds will remain weak, given not so strong market dynamics (read tight liquidity). These include the likely Rs. 10,000 crore advance-tax outflow and the forthcoming monetary policy. Moreover, bond funds remain hesitant participant with the dividend tax changes and should also pull out now to pay hefty dividends before March 31.