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Inflation Halts Recovery

After ruling low amid worries over high global crude prices, Indian bond prices started recovering post-news of issuance of floaters in the bond auction. But a much sharper rise in inflation spoilt the party towards the end.

The volatility in the Indian bond market is getting worse by the day. Surging global oil prices, a steep rise in domestic inflation and expectations of further hikes in US interest rates have played havoc in the market in the week gone by. The yield on the 10-year benchmark bond (GOI 2014, 7.37%) rose to a new 16-month high of 6.25 per cent mid-week before closing at 6.21 per cent on Friday – up 4 basis points over the week.

From the very start of the week, market players stayed cautious on growing concerns over record highs that global crude oil prices were touching. West Texas crude rose to $44 per barrel for the first time in the 21-year trading history of New York's Nymex exchange. Brent crude too surged to $41.16 per barrel as against $39.7 per barrel in the previous week. This led to a sharp drop in the trading volume in the first two trading days as investors were worried that this could drive domestic inflation higher. Consequently, the 10-year yield touched a high of 6.25 per cent on Tuesday. Investors were also awaiting the government's announcement on the date and type of bond it would issue in the schedule auction of Rs 8,000 crore.

But as the government announced that a large part of the auction would comprise of floating rate bonds, it brought smiles on the faces of bond investors. They welcomed the comment, as floaters act a good hedge against interest rate risks. According to the RBI borrowing calendar, the government would issue 10-14 year bond for Rs 6,000 crore and a 20 years bond for Rs 2,000 crore between August 2 and 9. Expenditure secretary Dhirendra Swarup's comment that there could be more floating rate issues if required also buoyed sentiment. This resulted in greater activity in the bond market as trading volume crossed Rs 3,000 crore by Thursday after remaining under Rs 2,000 crore in the first two trading days of the week.

Then came the biggest bombshell -- The inflation for the week ended July 24, rose to a three-and-a-half year high of 7.51 per cent, up from 6.52 per cent a week before. This created a panic like situation in the market and the price of 10-year bond fell by Rs 1.05 on a single day. The yield on the 10-year benchmark once again climbed to 6.21 per cent. After the inflation figures were out, India's Chief Economic Adviser Ashok Lahiri stepped in and said that he was not surprised by the inflation number and that it was due to a statistical base effect. He said that inflation will come down by mid-August, but these pronouncements failed to stop bond yields from rising.

The rise in yields was more pronounced in the government securities as compared to the corporate bonds. Hence, the yield-spread between the 5-year corporate bond and government security of similar maturity narrowed to 90 basis points this Friday vis-a-vis 93 basis points in the previous Friday.

The liquidity in the market continues to be comfortable with the total outstanding at the RBI's 7-day repo auction remaining above Rs 51,000 crore. Call rate too remained below the repo rate of 4.5 per cent throughout the week.

The rupee gained 8 paise against the US dollar over the week to close at Rs 46.36/$ on Friday. The Indian currency ruled firm as month-end demand for dollars from importers receded. The expectation of more foreign investments in the equity market also helped.

Outlook
In the near term, the inflation is further expected to tread upwards due to higher petroleum prices. In the last week of July, domestic oil companies have raised petrol and diesel prices, whose impact will be felt on the inflation figures in coming weeks. The rise in international crude price is also a cause of concern, as this will further add to inflation worries. A sustained high inflation may affect domestic currency as well, as it would erode purchasing power and hence may lead to rupee depreciation.

The market is also awaiting the US Fed's meeting scheduled for August 10, 2004. Any further rise in US interest rates may put pressure on RBI to review its current stance on domestic interest rate. The US Fed has raised its key funds rate by 0.25 per cent last month. But the revival of monsoon is a welcome sigh for the economy, as good agricultural harvest could go a long way in containing inflation in times to come.