The Hindu Business Line : Inflation fears hang over bond markets

Last week's figures failed to capture the impact of the coal price increase, which was expected to have a cascading effect on electricity tariffs and push the numbers beyond 6 per cent.

BONDS remained steady at weak levels during last week as traders waited anxiously for the Government's borrowing programme for the fiscal year.

Traders said there was yield stability due to low foreign currency inflows And was little outflow by way of importer demand in the market. Oil importers, after covering their exposures for the season, took off from the markets.

What also contributed to the stability at the low levels was the lower than expected Fed funds rate hike (the rate at which overnight funds are lent by US savings institutions and banks).

Last week, Fed funds rate was hiked by a small 0.25 per cent (25 basis points) when markets were expecting a rise of at least 0.50-0.75 per cent. As a result of this lower than expected increase, there would have been a strong recovery but for the liquidity mop-up. The RBI mopped up close to about Rs 20,000 crore during the week from the markets through its twin bonds issues and the market stabilisation scheme. Part of this was due to the coupon flows amounting to Rs 1,790 crore. The mop-up also coincided with redemptions of some Government securities, which included treasury bills. The banking system, despite the low foreign currency inflows, remained flush with liquidity on account of low credit off-take and large deposit rush. This was evident from the mop-up of close to Rs 10,500 crore through the week- end 7 day repurchase.

The twin Government security issues sailed through with little difficulty. The cut off yields for the 6.13 per cent maturing in 2028 was fixed at 6.70 per cent, though the weighted yield was 6.69 per cent. Similarly the 11-year floating rate bond also was fully subscribed.

The liquidity rush also helped in stabilising the ten-year yield to maturity at 5.81 per cent - almost at the same level as the previous week - though this had touched an intra-week low of 5.71 per cent also. The spread between the one-year and 24 years last week remained at 195 basis points, slightly lower than the previous week's level of 200 basis points. Volumes thought remained low at about Rs 3,500 crore.

The new life insurance companies were among the big sellers. They sold when yields dropped slightly. This was done in a bid to raise funds for enlarging their investible corpusesLife insurers are typically long-term investors, though during the last few weeks some of them were trading in the hope of advancing their breakeven deadlines. But traders anticipate the steady trend to remain on course during the week.

Part of this anticipation was prompted by statements from the Government that fiscal reforms would remain on course. In fact, the Finance Minister has already indicated that the fiscal deficit would be retained at the same levels.

Some bankers said that the poor US economic data and lower than expected Fed rate hike were likely to increase foreign exchange flows into emerging markets, particularly India. The Fed funds rate hike in fact led to a fall in ten year yields in the US by at least 30 basis points to 4.55 per cent, down from 4.85 per cent last week.

Traders said that further hikes in the Fed rate were unlikely during the current year in view of the poor employment growth. This, traders said, was likely to translate into higher flows into emerging markets, especially India, expanding reserve money flows tempering any big rise in yields.

But this is an optimism that is not shared by all traders. This is because forward premia have gone beyond 1 per cent for this first time in six months. Forward premia for 12 months is now close to 1.75 per cent, and for six months it was 1.69 per cent. Part of this rising premia stemmed from exporters withholding their inward remittances, anticipating a rupee depreciation. Since May, the rupee has depreciated by about 1.5 per cent. Last week's foreign currency data, however, indicated an out flow of $525 million.

Traders said that the rising premia and the outflows were partly due to arbitrage avenues created by the non-deliverable forward against the rupee and hedge funds. But net foreign exchange flows into the country since May has not been significant, and reserve growth has faced resistance at $120 billion.

Moreover, inflation worries continue to dog the markets. Real yields continued to be negative up to 10 years. Besides, there was increasing suspicion that the inflation figures understate the reality. Last week's figures failed to capture the impact of the coal price increase, which was expected to have a cascading effect on electricity tariffs and push the numbers beyond 6 per cent.

Accordingly bankers said that despite the possibility of a slight expansion in reserve money, the upside risks on yields were high. This is despite the fact that credit deposit ratios continue to be low, down to about 54 per cent from 58-59 per cent seen till April. Evidence of the upside risks on yields could be seen in the rising yield spreads between sovereign and sub-sovereign spreads. Sub-sovereign spreads were about 130 basis points above identical sovereign yields. For instance, the HDFC 5.85 per cent 2009 ended the week at 6.5 per cent. Clearly, borrowing costs are now expected to tighten especially after the peak season begins.