The Hindu Business Line : 10-year yields poised for 7.5 pc

INDIAN bonds have been on a seesaw. From the depths of 4.95 per cent, 10-year yields rose to 7.35 per cent in the course of 2003 and 2004 - not in a straight line but with significant volatility. However, after crossing 6.25 per cent, there was hardly any looking back.

End-2004 and early-2005 saw a rally to 6.5 per cent, after which they rode back to over 7 per cent. The last few weeks have again seen yields fall to the 6.75 per cent levels.

To an extent, domestic bonds do tend to move in sync with the US bonds. Thus, the sharp drop in US yields to below 4 per cent did evoke a corresponding downward reaction in our bonds. However, while the correlation is good, it is far from being a one-to-one relationship.

What is the prognosis for the future? As far as the US is concerned, there is a view that yields have more downside, to possibly the region of 3.5 per cent.

In his Congressional testimony last week, the US Fed Chairman, Mr Alan Greenspan, did not see any economic slowdown on the horizon and said the Fed would continue with its "measured" rate hike policy. If bond yields do not rise still, it will mean a flat yield curve. However, if yields keep falling, we will end up with an inverted yield curve - invariably, in the past, a harbinger of recession. Mr Greenspan thinks it will be different this time.

Given the accelerating pace of activity in our economy and rising energy prices, it is difficult to see inflation push much below the current levels. With oil prices zooming, the import bill is going to be hefty. Add to this the consumer boom in foreign goods; the trade balance will clearly shift decisively to the negative territory.

Foreign investments of direct and portfolio types should offset some of the deficit but not entirely.

Part of the rise in bonds is clearly the result of the huge liquidity in the system, deftly being mopped up by the RBI through its issues of MSS bonds. The result is that reverse repo funds flowing into the central bank have dropped from Rs 30,000 crore and more to the neighbourhood of Rs 10,000 crore. Increasing credit offtake at better rates than gilt yields will also reduce the attraction of Government bonds.

The rupee will be under pressure with in this situation of a rising trade deficit not compensated fully by capital flows. There will be little need for the RBI to intervene in dollar support - another significant source of market liquidity - as from 2002 to 2004.

The upshot? Bond yields should start going up, perhaps to about 7.5 per cent on 10 years.

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