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How Far is the Bottom?

The 10-year benchmark yield slid further to touch a low of 6.32 per cent. With state government auction scheduled for the coming week, there may be some liquidity squeeze. With no other auction next week, gilt prices are likely to remain range-bound.

Owing to comfortable liquidity in the markets, gilt prices continued to move up. The BJP's landslide victory in Gujarat elections also buoyed the market sentiment. This victory provided some assurance to the market that economic reforms would pick up speed now. Consequently, the yield on the 10-year benchmark (7.40%, 2012) GOI security ended the week at a new low of 6.32 per cent – down 5 basis points (bps). During the middle of the week though the yield inched up marginally after RBI set a higher cut-off yield for the 91-day T-Bill auction. However, that was short-lived and the yield fell further on Friday.

More interestingly, higher trading volumes accompanied rise in gilt prices. Average trading volumes touched Rs 6,000 crore after two consecutive weeks of low trading. Much of the activity, however, was concentrated at the longer-end of the yield curve. As a result, the yield on the 20-year GOI Security (8.35% 2022) fell by 12 bps and that on the 15-year paper (8.07% 2017) dropped 10 bps. In comparison, the yield on the shorter-maturity paper, for instance, the 2-year GOI security (12.5% 2004), fell by just 3 bps.

Ample liquidity in the money market was reflected in the form of huge outflows aggregating Rs 39,100 crore towards daily repo auction. And the call rates, after touching an intra-day high of 5.9 per cent on Wednesday, finally closed the week in the 5.60-5.70 per cent band. The call rate rose on Wednesday following the central bank's announcement, sharply curtailing banks' overnight lending and borrowing to nurture a term-money market and to make the daily repo auctions more effective.

According to the new rule, banks' lending limits have been halved to 25 per cent of their net-owned funds and the borrowing ceiling has been lowered to 100 per cent of net-owned funds (previously 150 per cent) or two per cent of aggregate deposits, whichever is higher. This has resulted in huge investments in corporate bonds. Consequently, the spread between the 5-year AAA bond and similar-maturity government securities widened from 31 bps on Monday to 36 bps by Friday. This also indicates that the yield on government securities fell more sharply than the yield on corporate bonds.

In the forex market, the rupee appreciated by 17 paisa over the week to close at Rs 48/$ on Friday – the year's closing high -- buoyed by increased dollar remittances by exporters. The RBI intervention did little to stop the rupee from appreciating. However, the market largely ignored the increase in global oil prices. The Brent crude price surged to $28.95 per barrel on Thursday, amidst increasing war fears in Iraq and a two-week-old strike in Venezuela, which has paralysed the oil industry there.

Outlook
The RBI will conduct state government auctions worth Rs 3,340 crore on Monday. Thus, the concern over possible liquidity squeeze may push bond yields further downwards, though marginally. With no further auction scheduled for the coming week, gilt prices are likely to remain range-bound. The rupee is likely to appreciate further following greater interest rate differentials and due to the weakening dollar globally.