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Yields Harden Further

Though inflation fell this week to 7.2 per cent, the rising global crude oil prices, the RBI setting a higher yield in the auction and the expected hike in domestic fuel prices kept the bond markets in the red

The mayhem in the bond market continued for the third straight week. Rising international crude oil prices, RBI setting a higher yield in the week's auction and the expected hike in domestic fuel prices has strengthened the market belief that the hardening of Indian interest rate is almost guaranteed. As a result, the 10-year yield climbed to a new two-year high of 6.77 per cent on Tuesday and closed a bit lower at 6.76 per cent on Friday – up 19 basis points over the week.

On Monday, the RBI auctioned the 11-year fixed rate bond for Rs 6,000 crore. However, the RBI set a higher-than-expected yield of 6.99 per cent at the auction, which dampened market sentiment. It raised fears that the government was comfortable with the higher yield and RBI may raise rates in the Monetary Policy Statement, which is due on October 26, 2004.

However, the Finance Secretary reiterated that the government favours a benign interest rate environment, so as not to hurt the ongoing growth. The industrial output has registered a growth of 7.9 per cent in August this year as against 5.7 per cent growth in the same month last year. The cumulative growth in the first five months of FY 2004-05 also stood at 7.9 per cent (5.9 per cent last year). But all this failed to restore market participants' sentiments and the yield hardening continued – the 10-year yield touched a high 6.77 per cent on Tuesday. There was no trading on Wednesday on account of the Assembly Election in Maharashtra.

But bond markets broke the 14-day losing streak on Thursday as traders expected a favourable inflation and the moderate rise in domestic fuel prices. The Indian oil companies have asked for a marginal increase of 1.7 per cent in petrol prices and a 6.6 per cent hike in diesel prices.

And finally, on Friday, when the inflation dropped, bond market stayed calm. Inflation based on Wholesale Price Index fell to 7.20 per cent for the week ended October 2, 2004 from 7.38 per cent in the previous week.

Despite all these developments in the Indian bond market the international crude oil prices continued its upward trend. In fact, on Tuesday, it touched a high of $51.1 per barrel but came down to below $51 towards the weekend.

The CRR hike early this month and the week's auction has affected market liquidity to some extent. The week's daily average subscription to the RBI's 1-day repos stood below Rs 7,000 crore as against Rs 10,000 crore in the previous week and Rs 15,000 crore in the week prior to that. The call rate, however, moved in a narrow range of 4.25-4.6 per cent.

Outlook

In the coming week, RBI will auction Rs 5,000 crore of 5-9 year bonds. This is further expected to tighten market liquidity. However, much of the market movement will depend on the cut-off yield set in the auction, as it will indicate the RBI's stand on the current interest rates. The 10-year yield has climbed 80 basis points in a short period of over a month. Hence, any further rise in yield will further strengthen the market expectation of a rate hike in the Monetary Policy Statement to be announced on October 26, 2004. Those reasons apart, the inflation number and the movement in global crude oil prices will be the other major factors to look forward to. And not to forget the magnitude of the rise in the domestic fuel prices.