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Fear Halts Bond Rally

Throughout the week, the market was gripped with fear of an open market operation. Though by mid-week the slide rally gathered pace and the ten-year benchmark touched 6.31 per cent.

After several weeks of gains, bond market turned jittery. The week showed an intra-week movement of almost 30 bps as the 10 years benchmark moved down to 6.31%, then up to 6.45% and then again close the week down at 6.40%. The 10-year benchmark traded at an all time low of 6.31% before closing the week at 6.40% close to last week's closing levels.

The RBI's announcement of another OMO of Rs 4500 crore of 10.95% 11 (which should actually reduce liquidity by almost Rs 6000 crore), is another indication of the RBI's intent to reduce liquidity. The first week of December last year witnessed a similar spate of OMOs and GOI auctions. The last week was an overall feverish week, which lost all its gains towards the end, in all the markets – short-term money markets, exchange rates, GOI securities, corporate debt and derivatives.

The short-term market was also highly volatile this week anticipating the RBI's intentions as regards the excess liquidity. Volatile exchange rate also added to complete the picture. Indian Rupee started trading the week at Rs. 48.19 / USD and touched a week high of Rs. 48.18 / USD, before shooting up to trade at a high of Rs. 48.32 / USD before closing at Rs. 48.29 / USD. The forward premia closed the week 15-30 bps lower across the curve.

A sharp drop in 364-day Treasury bill auction, at 5.36 per cent, on Wednesday also fueled the mid-week yield slide. The yield was below the repo rate of 5.5 per cent, at which short-term lending is done by central bank, fuelling hopes that a repo cut may be made later. After Thursday's warning the market was a little apprehensive on Friday, but the fears came true and a 9-year auction was announced for Monday. This auction for Rs 4,500 crore, instead of an OMO is being seen as liquidity mopping exercise by market players. Before this news could subside, the amount of the scheduled auction for 15-20 year paper was also increased from Rs 4,000 crore to Rs, 5,000 crore. All this news caused the bonds to be dumped and the ten year gilt benchmark ended just 6 basis points below the last week's close, at 6.39 per cent.

The corporate bonds also moved in tandem with government securities. The five-year benchmark for corporate bonds touched its all-time low of 6.314 per cent on Thursday, before recoiling to 6.42 per cent on Friday. The spread between the five-year corporate bond and gilt of similar tenure increased from 42 bps to 49 bps and was 41 bps on Friday.

The dependence on call market for fulfilling the CRR requirement is reducing, after the changed norms affected on November 16, 2002. The call rates this week stayed steady and ended at 5.0-5.25 per cent. With the spread between a ten-year paper and the repo rate shrinking to 85-90 bps, combined with the uncertainty, the mid-week repo auctions were aggressively bid. The activity in the debt market was also good, reflected by an average volume of Rs 6,300 crore.

Outlook

The open market operation this week is unlikely to be followed by another in December. Followed by the auction slated also in the coming week of Rs 5000 crore, the interest rates are likely to be under pressure primarily due to sentiments (i.e. over bought trading books) rather than the actual liquidity turning tight.