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Calm after the storm

The yield curve has become steeper as a new chapter is about to begin in the world of finance. RBI Governor Y. V. Reddy's views on interest rates and inflation numbers will be closely watched in the coming weeks.

After a lot of activity in the previous week, bond markets remained subdued and moved in a narrow range. The benchmark ten-year government security (2013, 7.27%) inched up by two basis points to close at 5.28 per cent. Though inflation continued its downward journey for the seventh consecutive week, touching its 31-week low of 3.71 per cent, it failed to impress bond markets. Average trading volumes at Rs 4673.6 core were also half those seen in the previous week.

The RBI's decision to go in for an open market operation (OMO) on September 8 kept the markets on tenterhooks. The sharp increase in petrol and diesel prices in the previous week also raised fears that inflation could rise and reduce the ability of the central bank to carry out its soft interest rate policy.

But the decision on the OMO should be seen in conjunction with the central bank's lowering the auction amount for the GOI 2023, 6.17% paper which was issued on Wednesday. In place of a scheduled auction of Rs 9,000 crore, the RBI conducted the auction for Rs 6000 crore only. The OMO of Rs 5000 crore (GOI 2019, 6.15%) is thus a measure to prevent any excess liquidity on account of the reduced auction. Bond markets have remained range bound and the ten-year benchmark closed unchanged at 5.27 per cent for three consecutive days between Tuesday and Thursday.

On the whole, these steps have had the desired impact of making the yield curve steeper. The spread between the five and fifteen year yields has risen to 75 basis points from 66 basis points earlier on.

The RBI also lowered yields at the auction of 91-day and 364-day treasury bills. The yield at the cut-off price at the 91-day treasury bill auction fell to 4.67 per cent from 4.75 per cent. At the 364-day treasury bill auction, the yield at the cut-off price fell to 4.7 per cent from 4.98 per cent.

Liquidity remained comfortable and the RBI received an average Rs 27,337 crore daily average subscription through the repo window.

After falling against the dollar by the middle of the week, the rupee continued to strengthen closing the week virtually unchanged at 45.87 to a dollar. The appreciation of the rupee over the past months has, however, taken a toll on exports. In July 2003, exports growth slipped to 5.75 per cent as compared to 11 per cent in June compared to the same months in 2002. As a result, export growth in April-July 2003 slipped to 9.29 per cent over the same period in 2002. Imports, in comparison, rose to 17 per cent and this could be an early indicator of a revival in the domestic economy.

Outlook
Markets await the arrival of the new RBI governor Y Venugopal Reddy and look forward to his views on the soft interest rate regime. Inflation numbers will be keenly watched for any signals of a hardening on account of rising fuel prices. Along with a revival of economic activity any possibility of increasing inflation, could result in a further steepening of the yield curve in coming weeks.