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Bonds Slip into Panic Zone

As the war clouds loomed large, bond yields made reversed direction and headed northwards. The sentiment is likely to remain subdued untill war fears abate.

This week was an unusually volatile for bond markets. With the US president making no bones about invading Iraq, the 10-year benchmark witnessed wild swings, from 6.03% to a high of 6.36%. Also, rumours about government making fresh borrowings from the market to prepay its foreign debt further added salt to injury. However, the government's announcement that it would make private placements with the RBI to raise money allayed these fears. As a result, markets breathed easy and the 10-year benchmark dropped 11 bps from mid-week's high of 6.21 per cent. Not for long though. The announcement of auction of state government paper to raise around Rs 900 crore saw yields move up, albeit marginally. Already, the RBI had conducted OMOs earlier in the month, which lead to a liquidity squeeze.

This is substantiated by the fact that subscriptions to daily RBI repos have come down sharply in January. From a daily average of Rs 8,000 crore in the first week, it has come down to Rs 1388 crore in the last week. The repo rate acts as a floor for overnight call rates, but ample liquidity in the system resulted in call rates ruling below the repo rate for a long time. This anomaly at the short-end of the yield curve is undergoing a correction now. In the last fortnight, call rates hovered above the repo rate of 5.75 per cent. That apart, the yield on another short-term benchmark, 91-Day Treasury bill -- which broke all short-term barriers -- has risen 20 bps during this month.

Sentiment at Bond Street became worse towards the end of the week as the US and Iraq inched closer towards war. Nervous selling saw a steep fall of Rs 2-5 in the government security prices at the long-end of the curve. While the 10-year benchmark moved up to 6.36 per cent, the entire yield curve moved up by 12-48 bps over the week. The panic is due to the fact that in case of a full-fledged war, crude prices will move up and deplete the forex reserves and, hence, put pressure on the domestic currency. Corporate bond market too couldn't escape this. The yield on the 5-year benchmark paper firmed up by 54 bps over the week.

However, the forex market had an interesting week. After opening weak against the greenback, rupee gained strength on account of dollar inflows and a depreciating dollar globally. Though the rupee is still believed to be undervalued by 4.5 per cent on the trade-weighted basis, but war fears saw a spurt in forward premiums, as companies covered their unhedged dollar positions. On the other hand, according to a RBI study the huge accretion of forex reserves in the current fiscal, which also lead to increased liquidity in the system, wasn't due to influx of NRI deposits. Instead, a current account surplus and a rise in export remittances have primarily contributed to huge forex reserves. However, the pace of growth of deposits has remained consistent with the earlier trend.

Outlook

Bond markets are in a nervous zone and may continue to remain lacklustre in the near future with sentiments being guided by the possibility of war. This uncertainty has kept market participants on the sidelines as volumes dried up this week. However, in case markets turn more volatile, the RBI is likely to lend support.