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Some Recovery at Last

After three harrowing weeks, Indian bonds made some recovery this week. Though inflation continued to climb, it is expected to start declining once the custom and excise duty cuts on petrol and diesel come into effect.

It was a relatively good week for the Indian debt market. The soothing comments from the Finance Minister on interest rate, reduction in the tenure of bond issuance and the cut in customs and excise duties on petrol and diesel helped bonds recover some ground. The yield on the 10-year benchmark bond (GOI 2014, 7.37%) dropped 15 basis points in the first three trading days to 6.47 per cent. However, the higher yield set in the bond auction led to some correction and the 10-year yield finally closed at 6.56 per cent on Thursday – down 6 basis points over the week. Indian debt and currency markets were closed on Friday for a local holiday.

The bond market opened on a buoyant note on Monday following the Finance Minister's weekend comments that there was no need to worry about interest rates despite the recent surge in inflation. On Tuesday, the government announced that it would auction Rs 5,000 crore worth of 1-year bond under the market stabilisation scheme instead of a two-four year bond issue as scheduled earlier. This reduction in tenure helped in lifting market sentiment and the 10-year yield dropped to below 6.5 per cent.

But this euphoria was short-lived. At the auction on Wednesday, the RBI set a lower cut-off price (higher yield) on the one-year bond under the market stabilisation scheme (MSS). In a way, this meant that the RBI is comfortable with higher yields and that really hurt market sentiment. And the yield once again moved above 6.5 per cent on Thursday.

Liquidity in the market returned to comfortable levels in the week ended August 19, after remaining tight in the previous week due to auction outflow. Further, the overnight repo auction that has been re-introduced from this week got a good response. The daily average subscription at the 1-day repo window was Rs 21,680 crore. Call rate too remained below the repo rate of 4.5 per cent. In fact, on Thursday, the call rate fell to 3 per cent because there was no demand for funds as most banks had fulfilled their SLR requirement in advance.

Meanwhile, the government also undertook some fiscal measures to curb rising inflation resulting from higher global crude oil prices. The customs duty on petrol and diesel had been slashed to 15 per cent from 20 per cent and the excise duty on petrol to 23 per cent from 26 per cent with effect from August 18. This is expected to provide some relief to Indians from inflation, which is ruling at a three-and-a-half year high. For the week ended August 7, inflation continued its rising trend and stood at 7.96 per cent as compared to 7.61 per cent in the previous week. The global crude oil prices too hit a new high this week as Nymex crude futures touched $49 per barrel on Friday following increased violence in Iraq. The rupee remained at the last week's level of Rs 46.31/$ on Thursday (Friday being the holiday).

Outlook
In the coming week, the RBI will auction state government bonds of Rs 1,186 crore on Tuesday and 91-day Treasury bills of Rs 1,500 crore under the MSS on Wednesday. Since liquidity has returned to normal, all this is expected to go through comfortably. There were also rumours that the government would raise the size of MSS from the current Rs 6,000 crore to control inflation. But that fear is also over as the government has ruled out any such plan for now. This is expected to comfort the bond market investors.

A sustained high inflation is daunting the Indian debt market at present. Though the government has taken steps to check inflation by reducing customs duties on petrol, diesel and non-alloy steel, but till inflation actually drops, the market is expected remain range-bound. Global oil prices have started coming down on Augsut 21 following of easing tensions in Iraq, which is good news.