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Yields Head North

With liquidity mopping exercises -- the flavour of the season -- Indian bond yields moved sharply up. The 10-year benchmark finally closed the week up 14 basis points at 5.11 per cent. For the next move, look to the RBI and its monetary policy

This week, Indian bond yields took a U-turn thus reversing its four-week long trend of falling yields. The scheduled auction of Rs 5,000 crore followed by an open market operation (OMO) of Rs 3,500 crore and then the not so encouraging comments from the apex bank, all played their part in the current rise in bond yields. However, with inflation falling below 5 per cent after three weeks led to some buying in the last trading session. As a result, the yield on the 10-year benchmark (2013, 7.27%) after touching a high of 5.13 per cent closed at 5.11 per cent on Friday – up 14 basis points over the week. The inflation based on wholesale price index fell to 4.95 per cent for the week ended October 11 from 5.08 per cent a week earlier.

On Wednesday, the RBI Deputy Governor Rakesh Mohan told "We felt that the way the market was going, perhaps the expectations were not rational. There were extraordinary expectations." His comments came just after the RBI's announcement of an another OMO of Rs 1,000 crore on the coming Monday. He clarified that this is meant to manage the market's expectations. This could well be an indication that the RBI is not going to cut the repo rate in the forthcoming monetary policy on November 3, 2003.

Last week, the central bank auctioned a 15-year bond for Rs 5,000 crore on Tuesday followed by an OMO of 3-year bond for Rs 3,500 crore on Thursday. Though the market easily digested the schedule auction, the higher yield set at the OMO added to the uncertain outlook for bonds.

That apart, RBI also introduced a slew of measures to curb excess liquidity. It held a 28-day repo auction this week along with the usual overnight repo auction. This is for the first time since 2000 that RBI has introduced such longer-duration repos to absorb liquidity. Thus liquidity was tight this week with the daily average subscription to RBI repos falling to Rs 7,500 crore from Rs 14,000 crore in the previous week. These steps also led to a rise in call rates, which went above the repo rate of 4.5 per on few occasions.

RBI has also slashed the ceiling on the interest rate that banks offer to NRIs on rupee-denominated deposits. The rate is now capped at 0.25 per cent above the London Inter-bank Offered Rate (Libor) instead of 1 per cent earlier. This could slowdown the fresh dollar inflows, which has been one of the main sources of liquidity in the bond market. The rupee, however, after touching a high of Rs 45.36/$ on Monday, closed at Rs 45.32/$ on Friday – up 2 paise over the week.

Outlook
Though all eyes are now set on the forthcoming monetary policy, the increasing intervention by RBI could well spoil the party. However, the expectation of a rate cut, fall in inflation and the increasing forex inflows should keep liquidity comfortable. Thus the 10-year yield is likely to stabilise at the current level till November 3 – the day RBI will announce the monetary policy.