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Markets on a High Alert

Bond prices crashed for the third consecutive week. The yield on the 10-year benchmark closed at 6.4 per cent. Though the liquidity situation has improved, bond prices won't move up till the war clouds disappear.

The bears continued to wreck havoc at Bond St. War fears, rise in inflation and fading hopes of a repo rate cut all added to the markets woes. The yield on the 10-year benchmark (9.81%, 2013) after touching an intra-day high of 6.5 per cent on Friday closed at 6.4 per cent – up 4 basis points (bps) over the week.

The liquidity situation, however, improved following sustained forex inflows and dollar-buying by the central bank. The daily average subscription to RBI repos rose from around Rs 1,500 crore in the previous two weeks to touch Rs 5,850 crore. Tight liquidity in the past weeks had seen call rates hover above the repo rate of 5.5 per cent. Enhanced money supply during the week saw the call rate largely stay below the repo rate, ending the week in the 5.25-5.50 per cent band.

Despite comfortable money supply, market players stayed on the sidelines. This was amply reflected in the decline in daily average trading volumes in the wholesale debt market. The volumes came down from over Rs 6,000 crore a month ago to around Rs 3,000 crore this week.

The same story was repeated in the corporate bond market too. However, the yield on corporate bonds rose more sharply vis-à-vis gilts. Therefore, the spread between the 5-year benchmark corporate bond and a similar-tenure GOI security widened to 90 bps from last week's 80 bps.

The yield curve has become steeper now, thus ruling out a repo rate cut in the immediate future. For instance, the spread between the 10-year bond and the 24-year bond widened from 41 bps last week to 61 bps this week. Similarly, the spread between the 2-year paper and the 10-year paper widened from 56 bps a week earlier to 67 bps.

However, what's been more worrying has been the rise in inflation, which touched 4.42 per cent in the week-ended January 18, 2003, from 3.72 per cent the previous week. This is likely to rise further if war happens and crude prices move up. The price of Brent crude touched $31.94 per barrel on Friday.

A rise in oil prices though had no impact on the rupee. The domestic currency continues to strengthen amidst robust forex inflows from foreign funds and exporters. The rupee ended the week 10 paisa stronger at Rs 47.7/$. The country's forex reserves rose to touch $73.6 billion in the week-ended January 31, 2003. Following the huge increase in forex reserves, the international rating agency, Moody's, upgraded India's foreign currency debt rating. This is likely to give Indian borrowers more room to raise funds at better rates abroad.

On the other hand, the Indian economy may be in for a rough ride. According to the Central Statistical Organisation, the economy is expected to grow by just 4.4 per cent in 2002-03 compared to 5.6 per cent in 2001-02. Drought played the spoilsport, leading to a slump in the agricultural sector. In comparison, other sectors are poised for better growth. For example, while the manufacturing sector is likely to grow by 6.1 per cent as against 3.4 per cent growth over the previous period, the construction sector is likely to grow by 7.1 per cent vis-à-vis a 3.7 per cent growth in 2001-02.

Outlook

Although the liquidity situation has improved, bond prices won't move up until a clear picture emerges on a possible US-Iraq war. This will continue to impact oil prices, which, in turn, will affect domestic inflation rate, and consequently, bond prices. And with no repo rate cut in sight, the bond market is lacking a trigger. We maintain a cautious outlook for the week.