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Repo Hike Spooks Bond Market

Though inflation stayed flat at 7.1 per cent for the second successive week, the 25 basis points repo rate hike announced in the RBI's Mid-term Policy Review played spoilsport in the Indian bond market

RBI Governor Y.V. Reddy finally came in action this week. In the Mid-term review of Annual Policy Statement for FY 2004-05 announced on October 26, he raised the repo rate by 25 basis points to 4.75 per cent. Though the bank rate has been kept unchanged at 6 per cent, inflation forecast has been revised upward to 6.5 per cent as against 5 per cent projected earlier. The GDP growth projection for 2004-05 has also been lowered to 6.0-6.5 per cent from 6.5-7.0 per cent earlier. All these sent the bond market into a tizzy and the yield on the 10-year benchmark (GOI 2014, 7.37%) shot up 15 basis points in a single day (October 26) to close at 6.82 per cent.

On Thursday, the 10-year yield went up another 11 basis points to tough a two-year high of 6.93 per cent as the government said that it would continue with its Rs 8,000 crore borrowing plan in the first week of November. The RBI has also planned to sell 10-year state government bonds worth Rs 6,200 crore in the coming week. This dampened the sentiment, as the market liquidity has been slightly tight in the past few weeks due to banks' stepping up of commercial lending.

Bond yields, however, eased a bit on the last trading session, as the inflation remained at 7.1 per cent in the second straight week ending October 16, 2004. Those apart, easing international crude oil prices raised market expectations that the inflation would start falling in coming months. Earlier, on Friday, the Finance Minister said that the government could take more measures to tame inflation. But market recovered later as oil prices witnessed sharp fall after China raised its interest rates on Thursday after a long span of nine years. The Nymex was trading at $51 per barrel--down from Monday's high of $55.67 a barrel. Hence, the 10-year yield closed slightly lower at 6.86 per cent on Friday–up 12 basis points over the week.

Though daily average subscription to RBI's 1-day repo witnessed slight improvement--from Rs 2,500 in the previous week to average Rs 7,340 crore, call rates remained in the higher band of 4.50-4.80 per cent throughout the week. In the current Mid-term Policy Statement, the RBI has taken few steps to facilitate liquidity management in a flexible manner. Effective November 1, 2004, only overnight (1-day) fixed rate repo and reverse repo will be in existence and the auctions of 7-day and 14-day repo would be discontinued.

While repo rate has been hiked by 25 basis points, the spread between the repo rate and the reverse repo rate has been reduced by 25 basis points from 150 basis points to 125 basis points. Accordingly, the reverse repo rate will continue to remain at 6 per cent. Moreover, the RBI has proposed to switchover the international usage of the terms 'repo' and 'reverse repo' with effect from October 29, 2004. With such a switchover, the fixed reverse repo rate will be 4.75 per cent and the repo rate will be available with a spread of 125 basis points at 6 per cent.

The rupee gained 35 paise over the week to close at a four-and-a-half month high of 45.38/$ on Friday on the back of falling crude oil prices and a weak US dollar overseas.

Outlook
Global crude oil prices started easing after Chinese interest rate was hiked on Thursday. Market is assuming this as a good signal since it will help in containing domestic inflation and would subsequently reduce the further rate hike expectations. Apart from the movement in international crude oil prices, the bond market will also look forward to the government's stand on the domestic fuel prices. And not to forget the cut-off yield to be set in the forthcoming auction of Rs 8,000 crore government bond and Rs 6,200 crore state government bond, which will provide the future course of action in the bond market.