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The Same Sob Story

War fears and rising inflation continue to haunt the bond market. The yield on the 10-year benchmark went up by 36 basis points. The outlook remains gloomy due to tensions in the Gulf and tight liquidity in the bond market

It was yet another turbulent week, with bond prices touching new lows. The reasons for the dreary show were the same as last week -- rising inflation and war fears. The 10-year benchmark (2013, 9.18%) yield touched a high of 6.84 per cent during the intra-day trade on Friday. It, however, closed at 6.76 per cent as traders bought bonds at cheaper prices. To add salt to injury, the RBI Governor Bimal Jalan's statement ruling out a repo rate cut in the near future further dampened sentiments.

However, Jalan has assured that a soft interest rate bias would continue. Also, that he wasn't really worried about rising inflation. In the past few weeks, bond yields have risen on account of this. The inflation based on wholesale price index, rose from 4.42 per cent in the previous week to 4.61 per cent in the week-ended January 25, 2003. Increasing oil prices have been largely responsible for this. The price of brent crude touched a 27-month high of $32.57 per barrel on Friday amidst war fears. This also took its toll on rupee, which turned weaker by 15 paisa over the week and closed at Rs 47.85/$ on Friday.

The trading activity, however, remained subdued in the wholesale debt market, as investors were uncomfortable in taking new positions. The average daily trading volumes came down from around Rs 3,000 crore last week to Rs 2,200 crore, far less than what it was a month ago (Rs 6,000 crore).

Over and above that, liquidity was tight in the market, amply reflected in higher call rate, which remained above the repo rate of 5.5 per cent. On Friday, the call rate closed in the 5.75-6.00 per cent band. The daily average subscription to RBI repos also fell from around Rs 6,000 crore in the previous week to Rs 2,162 crore this week.

Corporate bond yields too rose to new highs. The yield on the 5-year benchmark closed at 7.26 per cent. However, in comparison to gilts the rise wasn't much. Therefore, the spread between the 5-year benchmark corporate bond and a similar-tenure GOI security narrowed to 74 bps from last week's 90 bps.

As for the economy, our industrial sector has witnessed robust growth. According to the data released by the government, the sector grew by 5 per cent in December as against 3 per cent growth over the corresponding period in the previous year. Also, industrial output during April-December moved up by 5.3 per cent. All this confirms that interest rates aren't likely to come down in the near-term. That apart, industrial recovery may lead to credit off-take from banks -- the biggest investors in the debt market -- that could squeeze liquidity in the debt market. The non-food credit from banks has already increased by Rs 5,269 crore in the last fortnight.

Outlook
The yield on the 10-year benchmark is up 91 bps from its all-time low of 5.85 per cent as on January 22, 2003. Although the UN weapon inspection team has told the Security Council that they haven't found any weapons of mass destruction in Iraq, the outlook still remains hazy. Unless the issue gets resolved oil prices will continue to go up. This, in turn, will impact domestic inflation and, subsequently, bond prices. For the moment, we continue to maintain a cautious outlook.