The Hindu Business Line : Bond yields will be range-bound

The 10-year gilts had closed at 7.15 per cent the previous day. The piece saw value in them, given the sharp run up in yields and the wide differential of about 3 per cent with US Treasuries. One hardly expected such a rapid rally as happened on December 1 itself when 10 years fell to 6.8 per cent levels - a drop of 35 basis points in just a day.

The immediate provocation was the RBI's announcement of the cancellation of MSS auctions, which had effectively drained the market of liquidity and pushed call rates up to over 6 per cent. The fall of the rupee in the wake of the surge in oil prices and narrowing dollar-rupee arbitrage spreads following the increases in US interest rates and rising forward premiums reduced capital inflows as also the necessity for the RBI to intervene in dollar support operations which had been the main source of primary liquidity and driven down bond yields.

In recent weeks, the market has digested more good news - the inflation picture has visibly brightened. With crop arrivals, prices of primary articles are on a downtrend. The latest figure shows the WPI declining to 7 per cent. Further falls are almost certain in the coming weeks and it would be no surprise if it falls to 6 per cent or thereabouts in the near future.

So are happy days here again for bonds? The flat answer is that it is too early to call. The RBI is hardly likely to be happy with a combination of 7 per cent inflation (though improving) and bond yields of 6 per cent.

The conclusion must be that the central bank will consider yield moves towards 6.5 per cent and below excessively premature.

For some time, liquidity did improve - call rates were down to the 4.75 per cent range till a week or so back - but has since tightened.

Overnight rates are at 6 per cent levels. While the RBI may not like more gains in bond prices, the flip (and favourable) side is that it will keep the market reasonably well-supplied with liquidity through the now well-established medium of reducing MSS issues.

Of course, its reverse repo rate of 5.75 per cent effectively acts as a check on call rates going out of control, which used to happen in earlier years before the central bank fine-tuned its liquidity and monetary management tools.

Although the inflation outlook is better, it is not benign. One cannot rule out another repo rate hike if the WPI does not decisively break through 6 per cent. That should put a floor on bond yields.

Expect, therefore, the short-term topside and downside of 10 year yields to be in the vicinity of 7 per cent and 6.5 per cent.

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