The Hindu Business Line : Bond market stays tight despite RBI intervention

BONDS went into a tailspin last week prompted by tightening liquidity in a market dominated by weakening foreign currency inflows and fears of a resurgence in inflation.

Traders said that oil companies were active , locking into the prices when they softened. Most of them are now terrified of a deterioration of political stability in West Asia from where the bulk of the oil is sourced.

Traders said that oil companies were also on tenterhooks over repeated reports of possible US military intervention in Iran.

The fear has mounted after Mr George W. Bush was re-elected President.

Supplies from Iran: Any destabilisation in Iran would likely hit India severely, traders said, since at least 32 million barrels of oil (4.36 million tonnes approximately) are imported from Iran annually.

Oil companies' entry into the foreign exchange markets coincided with the prices falling to about $48 a barrel.

At least 36 per cent of oil imports are based on forward contracts, where low prices would have a positive impact. The companies fund purchases through lines of credit from the domestic banking sector. Traders said these credit lines also partly contributed to the jump in credit demand during the last few weeks.

However, despite this scramble for foreign currency, there was little impact on the foreign exchange markets. Supply was not an immediate problem, since the flows from external commercial borrowings prevented spikes.

Forward premia rose, driven by this oil-inspired demand.

Forward premia, which for more than one year remained below 3 per cent, has advanced to about 3.5 per cent for up to three months.

For longer periods, it continued to hover around 3 per cent.

Spike in yields: This kind of demand led to a tightening of liquidity.

The tightening liquidity was evident from the sudden spike in yields at the 91-day T-Bill auctions.

The cut-off yield at the auction was 5.85 per cent, up from the previous week's 5.37 per cent.

In fact, this yield is now close to the bank rate of 6 per cent.

RBI intervention: The RBI intervened through 3-day repos to cool the markets towards the weekend pumping in Rs 3,940 crore. This is the first time in two years that the RBI was pumping in liquidity.

The intervention prevented the 10-year yield to maturity from hardening beyond 7.21 per cent on a weighted average basis. The previous weekend, 10-year YTM was 6.97 per cent. At current levels, the 10-year YTM was at a two year high.

The undertone in the markets remained weak. Daily average trading volumes were barely Rs 2,000 crore. Besides, the yield curve was characterised by severe skews. This was partly driven by large-scale selling by the banking sector participants. Life insurers picked up some long-dated securities that were trading at a par and below values.

Bear hug: But in a thin market, caught in a bear hug, even small volumes tended to have a big impact. The yield curve tended to become flat beyond 12 years. This was also evident from thin spreads between one year and 24 years. The spread was down to 117 points from last week's 145 basis points.

Thinning spreads, however, was not reflective of rising trading interest. Most traders believe that the contracting spreads were more driven by the selling wave that gripped banks.

Derisking portfolios: Most banks were moving to de-risk their portfolios. Derisking implied shrinking the average maturity of marked to market (MoM) securities.

The MoM securities include those falling in the `available for sale' and `held for trading' categories.

Shrinking the maturity normally takes place when liquidity is expected to tighten. But some of the banks were early birds in sensing the tightening liquidity.

In fact, some private banks had shifted to reducing the maturity of their investments as early as in May, when foreign exchange flows slowed down.

PSBs too join: Now, public sector banks have joined the rush to shrink the maturity of investment portfolios.

This would mean the reissue of the 7.95 per cent 2032 (Rs 200 crore) and the 7.55 per cent 2010 (Rs 6,000 crore) planned by the RBI this week is headed for some difficulties in view of the tight liquidity situation.

Traders anticipate that the market stabilisation component of the T-Bills (Rs 1,500 crore for 91-day and Rs 1,000 crore for 364-day bills) would be discontinued.

Commissions for PDs: Besides, traders also expect the underwriting commissions for the primary dealers to be kept high for the auctions, to prevent devolvement. The hardening yields also shrank the negative real yields. Based on the 10-year YTM, the spread between inflation and the 10-year YTM was 16 basis points.

Traders see the accelerating demand for credit and oil-driven foreign exchange demand would drive up the real yields into positive territory.

Forex inflows: Foreign exchange inflows for the last reporting week were $550 million. However, large components of it was driven by the ECB flows which was soaked up by the oil companies. The remaining was largely due to the dollar's depreciation against the euro.

Credit offtake: The tight liquidity was also evident from tempo of credit growth. Credit grew by Rs 37,792 crore during the last reporting week, though part of it was oil induced.

But even after netting for this oil effect, the growth has mostly come from the retail and from the manufacturing sector. Tight liquidity was also expected to trigger a scramble for deposits, traders said.