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Yields Head North

The RBI has announced new measures to manage liquidity in debt markets, which may result in a softening of short-term interest rates. Inflation continued to increase, thus putting an upward pressure on bond yields.

For the fourth successive week, yields on government securities have hardened. The ten-year benchmark security (GOI 2013, 7.27%) ended the week higher by 8 basis points at 5.21 per cent. This was still lower than the week's high of 5.25 per cent reached on Tuesday. This hardening of yields was accompanied with higher activity as average trading volumes during the week increased to Rs 3199.18 crore thus ending a month long period of falling volumes.

On Tuesday, the RBI released its report on liquidity management. According to this, the repo rate will be a rate-signalling device, and the daily repo will be replaced by a one-week repo. A new deposit rate will be evolved which will be below the repo rate. This will set the floor for overnight interest rates instead of the current repo rate. Another key proposal was to slash the rate paid on banks' cash reserves at a rate below the repo rate of 4.5 per cent, which was welcomed by market participants.

The market largely ignored the Reserve Bank of Australia's decision to raise its cash rate for the second successive month and yields fell in the next few trading sessions. The Rs 5,000-crore RBI auction of a 25-year bond (GOI 2028, 6.01%) at a lower than expected cut-off price, however, upset market participants. Before the auction, the same bond had traded at Rs 99.75 and at par a few days earlier. The cut-off price of Rs 96.90 translated into a 6.26 per cent yield. Bond prices consequently fell and the ten-year ended Thursday 5.17 per cent.

The real surprise came on Friday as inflation numbers once again headed northwards. The general price level, as measured by the Wholesale Price Index rose to 5.24 per cent for the week ending November 22. This was up by 0.12 per cent as compared to the previous week. Most of the increase was on account of higher food prices. However, it is expected that with the harvest in January, food grain prices should edge southwards and this should help in keeping a lid on inflation. Bond yields ended slightly lower at 5.21 per cent on Friday. Liquidity remained comfortable and the average daily subscriptions at RBI repo of Rs 28,035 crore was slightly higher than the previous week.

The rupee gained against the dollar in all trading sessions of the week to close the week at 45.60—a gain of 25 paise. Much of this was on account of higher dollar inflows into the equity markets. The rupee touched a 3-week high and is up 5.2 per cent from the start of the calendar year. Foreign exchange reserves touched Rs 96 billion in the week.

Outlook
No further auction is scheduled till January. Thus, liquidity should remain comfortable and inflation numbers will be keenly watched for any signs of softening. Much will also depend on how the new measures announced by the RBI work out.