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Yields Keep Falling

Comfortable liquidity and fall in inflation resulted in bond yields touching new lows. Despite an increase in the size of the 91-day T-bill auction, the fear of OMO still prevails. This may keep players on the sidelines.

Bond prices continued their sharp rise for the third consecutive week. Despite the auction outflow of Rs 9,000 crore this week, ample liquidity and the expectation of a further fall in inflation kept investors in the buying mode. The daily average trading volume rose 10 per cent this week over last week. The yield on the 10-year benchmark GOI Security (2013, 7.27%) ended the week at 5.55 per cent on Friday -- down 0.05 per cent. The inflation has, in fact, fallen in the last few weeks from 5.32 per cent as on June-end to 4.59 per cent in the week ended July 19, 2003.

Initially, bond prices fell on profit booking. This was in response to the RBI's decision to triple the size of the 91-day Treasury bill auctions to Rs 1,500 crore for the next eight weeks. This also resulted in a rise in yields at the shorter-end of the curve. The cut-off yield at the 91-day Treasury bill auction rose to 4.95 per cent from 4.75 per cent in the previous week. Similarly, the 364-day Treasury bill yield inched up to 4.97 per cent from 4.80 per cent a fortnight ago. All this raised the fear that RBI may initiate few more liquidity-mopping exercises to check the sharp fall in bond yields.

This fear got further strengthened following the RBI Executive Director Usha Thorat's statement that an open market bond sale could be considered to absorb excess liquidity in the banking system. Banks, which are flush with funds, have been making bigger investments in the bond market due to the lack of credit offtake from the industrial sector. In the current financial year, the non-food credit has grown by just Rs 4,388 crore as on July 25, 2003 as against Rs 56,370 crore in the same period last fiscal.

The fall in yield was sharper in the 8-20 year segment of the yield curve. Along with the rise in short-term yields, this resulted in making the yield curve flatter this week. For instance, the spread between the 5-year and the 10-year GOI security narrowed to 0.38 per cent this week as against 0.44 per cent two weeks ago. Moreover, the 10-year bond spread over the repo rate has narrowed to just 0.55 per cent now.

The week's auctions of Rs 6,000 crore worth of 8-year floating-rate bond and a 25-year bond of Rs 3,000 crore received good response in the market. This proved the fact that there is enough appetite for government bonds. High liquidity in the system has been the main factor driving the bond prices upwards this year. This week too, the daily average subscription to RBI repos remained high at Rs 29,217 crore -- an increase of 7 per cent over previous week. The call rate also remained below the repo rate of 5 per cent in most trading sessions except for Friday. Call rates closed higher (5-5.25 per cent) on the last trading session due to some late demand for funds by banks to meet their reporting Friday requirement.

The rupee gained 16 paise to end the week at Rs 46.01/$ on Friday. On Thursday, however, it touched a low of Rs 45.95/$ as Infosys sold huge amount of dollars, which it had raised through the American Depositary Shares offerings. Moreover, the weakening dollar against the euro in the overseas market has helped the rupee in gaining strength against the dollar.

Though the size of the 91-day Treasury bill auction has been raised, the market is still flush with funds. With no more scheduled auction left for the month of August, all eyes would now be on the central bank, as to when it announces more measures to squeeze liquidity. Thus, the outlook for next week remains cautious.