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Yields Harden on Inflation Fear

Hike in domestic fuel prices, rise in inflation and tight market liquidity resulted into sharp upward movements in the bond yields. The 10-year yield closed the week at a two-year high of 7.16 per cent

The inflation concern and tight liquidity drove up G-Sec yields to a new two-year high in the week ended November 5, 2004. The inflation, after remaining at 7.1 per cent for two straight weeks, once again shot up 7.38 per cent for the week ended October 23. Inflation is further expected to rise following hike in domestic fuel prices. Consequently, yield on the actively traded G-Sec (GOI 2015 7.38%) went up sharply by 29 basis points over the week to close at 7.16 per cent on Friday.

Liquidity in the market has almost dried up in the week gone by, resulting in higher call rate--it touched 5.75-6 per cent in the last two trading sessions. The subscription to RBI's overnight reverse repo (new nomenclature for repo) fell to mere Rs 510 crore and Rs 350 crore on Wednesday and Thursday, respectively. To ease this liquidity crunch, RBI finally infused Rs 3,940 in the market via repo auction on Friday. The central bank has also cancelled the sale of 91-day and 364-day treasury bills under the market stabilisation scheme (MSS) scheduled for November 10. This is expected to provide relief to investors, at least for the short-term.

The market struggling with tight liquidity saw a sharp decline of 40 per cent in its average trading volume to Rs 1,673 crore as against previous week's average volume of Rs 2,729 crore. The volume was so low that the 10-year benchmark (GOI 2014, 7.37%) was not traded on three trading sessions--Monday, Wednesday and Thursday. On Friday, the 10-year yield was at 7.17 per cent--up 31 basis points over the week.

Most of the market players were exercising caution from the very start of the week following the expected liquidity squeeze due to auction of Rs 8,000 crore bonds scheduled for the week. The market, however, took a breather midweek after RBI decided to close the sale of state government loans despite not being able to raise the target amount of Rs 6,200 crore. But as the government said that it would go ahead with its schedule auction of Rs 8,000 crore bonds on November 8, despite tight liquidity, bond yields again went up.

But the major surprise came on Friday, when the inflation figures were released. The inflation based on Wholesale Price Index (WPI) rose to a month's high of 7.38 per cent for the week ended October 23--up from 7.1 per cent in the previous week. A day before (on Thursday), the government also raised the price of petrol and diesel by over Rs 2 per liter and that of the LPG was hiked by Rs 20 per cylinder. Since the gap between the international and domestic price is too high, the government has further decided to raise price of LPG cylinder by Rs 5 per month for the next 26 months. This hike in prices are expected to further fuel inflation in coming months. However, India's chief economic advisor, Ashok Lahiri, said on Friday that the government's decision to raise retail prices of petroleum products would only have a small impact on inflation.

On the positive side, the international oil prices slid to a five-week low on Friday. The London Brent crude was down at $45.88 a barrel on Friday from $49.71 per barrel in the previous week. The rupee, on the other hand, gained 18 paise over the week to close at near five-month high of 45.20/$ on Friday tracking gains made by regional currencies due to weaker dollar and the speculation that the Chinese yuan may be revalued.

Outlook
As the treasury bill auction under the MSS (scheduled for November 10) has been cancelled, all eyes are now set on Monday's (November 8) bond auction of Rs 8,000 crore. Some of the market players are speculating that the auction might be cancelled. However, even if the auction takes place as per schedule, this is not expected to be fully subscribed following the liquidity crunch in the system. Moreover, the cut-off yield set on the bond auction will provide the future direction to bond yields movement. Though international crude oil prices have eased to a larger extent, still, market would be hoping for a further reduction in oil prices, so that the domestic fuel prices also comes down, which will help in containing domestic inflation.