The Hindu Business Line : Bonds continue to rally

Bangalore, July 22 Bonds continued their rally for the third consecutive week, powered by surging foreign exchange reserves and consequent reserve money expansion.

But traders said that the rally was also led by large deposit inflows. This contributed partly to the liquidity overhang in the financial markets. Deposits are surging in the banking system at an annual clip of about 24 per cent, as against credit whose growth decelerated to 22 per cent, a complete reversal from the last financial year.

The liquidity surge was also on account of the large foreign exchange inflows into the country, as the RBI continued its restrained intervention to prevent any excessive volatility in the foreign exchange markets.

The inflows were mostly on the capital account, both debt and non-debt. Inflows during the last few weeks through these routes were taking place at about $500 million a day.

With the demand not keeping pace from oil companies and importers and the RBI’s continued restraint, the exchange rate has sustained its appreciation.

Oil companies and importers purchased dollars for meeting their payment dues entirely from the spot markets. Few took forward cover. The absence of importer covering led to forward premia levelling for 30 days, and a premium of 0.2 per cent for three months, where as for six months and 12 months, it was less than 1.5 per cent.

The liquidity overhang, as a result, was evident from the high turnout at weekend liquidity adjustment facility auctions. At the two LAF auctions, bids for the reverse repurchases were Rs 1,05,210 crore, but the RBI accepted only Rs 3,000 crore, resulting in liquidity inundation.

The cap on the reverse repos was drawing bankers to the Treasury Bills, where the yields dropped. At the 91-day T-bill auction, the yield fell 62 basis points to 4.5 per cent last week from 5.12 per cent the previous week. This is the lowest level since June 2004. Though the bids, competitive and non-competitive, were about Rs 9,700 crore, the RBI retained only Rs 2,500 crore exacerbating the liquidity overhang. At the 364-day T-bill auction, the yields dropped to 6.58 per cent.

But the high liquidity benefited the Government’s twin auctions, where it raised Rs 9,000 crore through the reissue of the 7.27 per cent 2013 and the 7.95 per cent 2032. The yield to maturities (YTM) for both these securities were 7.59 per cent and 8.34 per cent respectively, the most competitive rates since 2005-end. But the low retention released liquidity resulting in pushing down secondary market yields.

As a result, the ten-year YTM ended the week at 7.77 per cent on a weighted average basis down 13 basis points over the previous week’s figure of 7.90 per cent.

The under tone remained firm during the week, evident from the rising daily trade volumes. At the NSE, the daily trade volume was Rs 1,150 crore.

At the Clearing Corporation of India’s window daily volumes have hit a high of Rs 9,565 crore. The outlook, however, was mixed. Buy-sell spreads have shrunk to just 5 basis points. In buoyant markets the spreads remain thin and widen when the conditions are not conducive. Besides, the yield spreads have also widened. Last weekend, the spread was 170 basis points indicating a linear yield curve.

The wide spread was largely on account of the chase for short duration papers by bankers. Favoured instruments included the 9.39 2011, especially where trade volumes have surged.

Besides, life insurers stayed away from the secondary markets in view of the high price of acquisition, when yields become more acceptable.

However, this was unlikely to be a long wait. One year real yields were down to 1.77 per cent, indicating an imminent correction. The drop in the real yield last week, over the previous week, was largely on account of rising inflation.

Consequently, traders said the liquidity tightening could yet return to haunt the markets in the coming weeks when peak season credit demand kicks in. Moreover, traders preferred to watch for the RBI’s policy announcement for the peak season, after the bankers meeting with the central bank.

Besides the RBI, there was also another genie influencing domestic yields — the Federal Reserve Board. The Fed is reviewing its key Federal Funds Rate on August 7. The Fed Funds is the overnight borrowing-lending rate among US banks. This is currently 5.25 per cent.