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Bonds Bounce Back

The fall in global crude oil prices, S&P's improved currency ratings outlook on India and the fall in domestic inflation triggered a sharp rally in the bond market. The 10-year yield closed at a month's low of 6.11 per cent.

Indian bonds made smart gains in the week gone by. A sharp drop in international crude oil prices, S&P's improved currency ratings outlook on India and the fall the domestic inflation helped investors restore their confidence back in the Indian bond market. As a result, the yield on the 10-year government security (GOI 2014, 7.37%) fell 45 basis points over the week to close at a one-month low of 6.11 per cent on Friday. This is the year's biggest weekly fall in the 10-year bond yield.

The week also saw a huge 86 per cent rise in the average trading volume -- from Rs 2,204 crore in the previous week to Rs 4,108 crore in the week ended August 27, 2004. However, the volume was slightly hit on Tuesday following the one-day nationwide bank strike.

From the very start of the week, there was growing consensus among bond market players that inflation has peaked and would start moving down. This, along with the unexpected good news that Standard & Poor's has improved its outlook on both India's foreign currency and domestic ratings, cheered the market sentiment. While the outlook on India's foreign currency rating has risen from BB stable to positive, the outlook on domestic currency rating has moved to BB stable from negative.

The major trigger for the week was the sharp drop in global crude oil prices. The Brent Crude price fell to $40.82 per barrel on Friday from $43.3 per barrel in the previous week. The rise in international oil prices had been one of the key factors driving inflation, which in turn has led to an upward revision in bond yields recently.

Interestingly, domestic inflation too fell, though marginally, to 7.94 per cent in the week ended August 14 as compared to 7.96 per cent in the previous week. However, the market gained the most on Friday – the 10-year yield dropped 13 basis points that day – especially triggered by RBI Governor's statement that he saw no need to constrain demand because supply shock was mainly responsible for the recent spike in inflation. The Finance Minister also made a similar statement on Saturday. Both have reiterated that interest rates would remain stable, which is good news for the Indian bond market.

The call rate remained in the 4.25-4.50 per cent range amid plenty of liquidity in the system. The comfortable liquidity was widely evident from an average Rs 20,000 crore being received at the overnight repo auction over the week. The rupee moved in a narrow range of 46.27-46.36 per US dollar over the week but closed at Rs 46.31/$ on Friday – unchanged since last Friday.

Outlook Between September 2-9, the RBI will auction Rs 6,000 crore 5-9 year bonds and Rs 4,000 crore 15-19 year bonds as per the government's borrowing calendar. Both these issues are likely to find enough takers, as there is plenty of liquidity in the market. The market is also awaiting the government's final decision on the size of the bonds to be issued under market stabilisation scheme (MSS). So far, the RBI has issued Rs 56,500 crore worth of T-bills and short-term bonds under MSS.

The biggest cause for concern has been high inflation. Apart from the high global oil price, we were also witnessing the nationwide truckers' strike. But as international oil prices have eased and the truckers' strike has been called off, inflation should calm down in the coming weeks. That apart, the reduction in customs duties on diesel and petrol together with the last week's cut in steel prices should also help in containing inflation. Hence, the outlook seems to be favourable for the bond market in the near term.