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New RBI Norm Lifts Bonds

Despite inflation crossing 8%, Indian bonds rallied as state-run banks bought heavily to make use of the RBI's new norm which allows banks to exceed the held-to-maturity limit of 25% of investments.

The recovery in the Indian debt markets continued for the third straight week. Though inflation touched a new high crossing 8 per cent, heavy buying by state-run banks following RBI's new investment norms for banks helped in driving up the bond prices. The yield on the 10-year benchmark government security (GOI 2014, 7.37%) closed at a one-month low of 5.93 per cent on Friday – down 18 basis points over the week. The drop in global oil prices also helped in improving market sentiment.

On Thursday, RBI issued new prudential norms on classification of investment portfolio of banks, whereby it allowed banks to exceed the present limit of 25 per cent of total investments under 'held-to-maturity' (HTM) category. To take advantage of this, banks will have to make full provisioning on the depreciated value of the securities prior to the transfer. The move is expected to insulate the SLR investments of banks from day-to-day market volatility.

This propelled banks to make heavy bond purchases in the market leading to a rise in bond prices. Higher bond prices would enable banks to take a lower hit once they transfer their SLR securities to HTM category, since the cost of shifting would be at the market price. This action from bank participants was largely responsible for the sharp drop in bond yield on Friday.

However, there was another school of thought that believes banks cannot push up bond prices alone and that the market believes that inflation has reached its zenith and must come down soon. Inflation based on Wholesale Price Index touched a new three-and-a-half year high of 8.17 per cent for the week ended August 21, up from 7.94 per cent in the previous week.

From the very start of the week, market participants have maintained the view that domestic inflation had peaked. Last week's statements by both the finance minister and the RBI governor that the interest rates were likely to remain stable in the near term also helped the market participants to remain cool.

The easing global oil prices and the weak US consumer confidence data, which meant that interest rate hikes would now take place at a slower rate, buoyed the market sentiment. The European Central Bank (ECB) also left interest rates unchanged at 2 per cent. Brent crude slipped to $40.2 per barrel on Wednesday from a high of $43.58 per barrel on August 23, 2004. But Russian oil firm Yukos's fresh warning that it would cut production to protest against the Russian court's order to seize $2.6 billion of its assets, led Brent crude prices to rise once again to $41.75 per barrel on Friday.

On the market liquidity front, the average daily subscription to 1-day repo was comfortably placed at Rs 32,262 crore and the total outstanding at the 7-day repo auction stood above Rs 11,000 crore throughout the week. And due to ample liquidity, the call rates too remained below the repo rate of 4.5 per cent over the week.

Outlook
The relaxation of banks' investment norm, which resulted in huge buying by state-run banks on Friday, is expected to restrict bond yields from moving up in the coming weeks as well so as to minimise their losses once they transfer their SLR securities to HTM category. The high inflation is still a cause for concern but is expected to start declining after mid-September. However, the coming week's inflation figure will still include the impact of the truckers' strike, hence a higher figure cannot be ruled out. International crude oil prices will be closely watched as they have once again started moving up after declining in the first few days of the week.

In the coming week, 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. Since there is no dearth of liquidity, both these issues are expected to sail through comfortably.

Overall, except for global crude oil prices, there is hardly any negative factor in the market.