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Yields Calm Down

Despite rise in inflation, bond prices continued their upward movement for the second straight week amid ample liquidity in the market. Yield on the 10-year benchmark gilt closed the week at 5.24 per cent.

Recovery in the Indian bond market continued for the second successive week. Initially, ample liquidity and the market expectation that the declining trend in inflation would continue this week too, kept the market sentiments in good stead. But since inflation didn't move down, the bond prices reversed their trend. However, bargain hunting by several cash-rich state-run banks restored bond prices from taking a larger hit. Consequently, the yield on the 10-year benchmark (GOI 2014 7.37%) after dipping to 5.23 per cent closed at 5.24 per cent on Friday – down 2 basis points over the week. In the corporate bond market, the yield on the 5-year benchmark bond fell by 2 basis points to close at 5.83 per cent on Friday, while its spread over the government security of the same maturity remained unchanged at 87 basis points over the week. Thus yields on the corporate bond fell in same proportion to that of the fall in gilt yields.

The inflation based on Wholesale Price Index rose to 5.94 per cent for the week ended February 21 as against 5.84 per cent in the previous week. And witnessing this, on Friday, the government made its first official admission that the inflation won't be reined in at 4-4.5 per cent as expected earlier. Chief Economic Adviser Ashok Lahiri said, "The 4.0-4.5 per cent forecast will be exceeded. But there is nothing to lose sleep over."

This was in sharp contrast to the Finance Minister Jaswant Singh's last week statement where he stood by the 4.0-4.5 per cent inflation forecast despite inflation hovering around 5-5.6 per cent over the past few weeks. However, Ashok Lahiri did not see any immediate impact of rising inflation on interest rates and expected edible and sugar prices to fall in the next week to 10 days. Despite so many debates over inflation, the trading activity picked up this week. The daily average trading volume rose to Rs 3,340 crore – up 16 per cent vis-à-vis previous week. This is a good sign for the market, as volumes ere on a continuous decline in the past three weeks.

Liquidity in the market is on a continuous rise in the recent months. This week, the daily average subscription to RBI repos stood over 46,000 crore on each trading session – the highest weekly average figure ever. Due to such high liquidity, there was no demand for funds in the market and the call rate remained below the repo rate of 4.5 per cent.

Huge dollar inflow has been the key factor driving up the liquidity, thus resulting in the burgeoning of Forex reserves. India's foreign exchange reserves rose to $108.36 billion in the week ended February 27 from $107.675 billion the previous week. The rupee, however, lost 5 paise against the US dollar this week to close at 45.29/$ on Friday.

The rise in inflation is worrying the bond market participants. However, a sharp increase in trading volume and abundant liquidity should keep the bond yields in the good stead. The market is also waiting the RBI's action plan as to how the Market Stabilisation Bonds will be issued. In the meantime, bond yields are likely to move in a narrow range.