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Hardening of Yield Continues

Despite a fall in inflation, bond yields continued their upward march. The government's proposal to launch market stabilisation bonds and the hangover of US Fed's stance on interest rate kept Indian bond markets on their toes

The bloodbath at the Indian bond markets continued this week too. The hardening of interest rates in the UK, change in the US Fed's stance on interest rate, and high inflation in India have been haunting Indian bond investors. The governments' plan to introduce stabilisation bonds by March 2004 has further added salt to the injured bond market. As a result all these, the yield on the 10-year benchmark (GOI 2014, 7.37%) went up by 6 basis points (bps) over the week to close at 5.27 per cent on Friday.

Though the inflation based on Wholesale Price Index fell to 5.8 per cent for the week ended January 31, 2004 from 6.12 per cent in the previous week, the fall was less than what the market expected. This is the first time in five weeks that inflation came below 6 per cent. However, RBI Governor Y. V. Reddy has reiterated RBI's inflation forecast of 4-4-5 per cent by end of March 2004. At a press conference in Patna, he said that the Indian economy is expected to grow strongly this year as well as the next year. "There are signs of hardening, not necessarily in the United States. But all monetary measures will remain status quo till the next policy, unless there are other things," Reddy added.

But the real jolt for the bond market came on Wednesday, after the government said that it was planning to introduce a market stabilisation bond in the current financial year to managed excess liquidity in the market. The liquidity in the bond market is on a continuous rise following strong dollar inflows. The market stabilisation bond will enable the government to issue bonds to RBI, which in turn would be issued in the market to mop up excess liquidity. This week too, the liquidity in the market remained on the higher side. The daily average subscription to RBI repos stood at Rs 37,486 crore – slightly lower than last week's figure. The call rate too remained in the 4.25-4.5 per cent band in all the trading sessions.

Though yields rose across the board, the rise was more pronounced at the shorter maturity bonds. For instance, the yields on the 5-year bond shot up by 9 bps this week, against a 6 bps rise in the 10-year bond yield. In contrast, the yield on the 15-year bond just rose by 1 bps. Consequently, the spread between the 5-year and 10-year bond narrowed to 0.21 bps compared to 0.23 bps last week. And the spread between 5- and 15-year bond narrowed to 75 bps against 82 bps in the previous week, thus making the yield curve slightly flat.

The rupee continued its gaining streak for the sixth straight week. This week, it gained 4 paise to close at Rs 45.23/$ on Friday. Meanwhile, India's foreign exchange reserves rose to $106.61 billion in the week ended February 6, 2004 from $105 billion in the previous week.

Outlook
The RBI will auction state government bonds worth Rs 4,200 crore on Thursday, which should be fully subscribed due to abundant liquidity. Bond yields are likely to remain at the current level with an upward bias. However, much will depend on the timing of the launch of market stabilisation bonds by the government.