Profit-taking may see bond yields hitting 6.90%

Indian markets had their best times moments last week after a long while as both equities and fixed income markets outperformed many developed and emerging markets.

There was more to follow from global market events than domestic developments and asset classes responded positively for most part of the week. First, the minutes of the May Federal Open Market Committee (FOMC) meeting suggested the US Federal Reserve would set a gradually increasing cap on the US dollar levels of Treasury and agency securities it would allow to run off each month. The caps would be gradually increased every three months to their fully phased-in levels. In addition to this plan, the minutes also suggested rate hikes would depend on the growth in economy. Rates stayed flat and shrugged these developments.

A more important development was the first downgrade in nearly three decades of China's sovereign credit rating by Moody's. The rating now stands at A1, with a stable outlook. Moody's cited rising liabilities and weakening financial strength as reasons for the cut. China's finance ministry dismissed the move as "groundless."

On the data front, US first quarter GDP was revised up to 1.2% from 0.7% and this showed higher consumer spending. Upbeat corporate earnings and positive economic data helped underpin a continued rally in US equities, with both the S&P 500 Index and the Nasdaq Composite Index hitting fresh all-time highs on Thursday.

In other developments, Manchester attack has resulted in raising of terror threat level. Brexit now is headed for war of words as European Union and the UK prepares for June 19 meeting.

Indian bond markets had a strong closing after a sustained rally through the week. The weekly auction cut-off was on expected lines. As highlighted in our previous notes, spread-compression has been a key driver with foreign institutional investors counters seeing record flows. Inflows for May have already crossed $3 billion. With outlook for the rupee stable and fears of inflation lower, the rally should continue. The odds of a dovish turn in the June policy is a hope that most in the bond street are playing. Traders are also drawing comfort from a report that the Reserve Bank of India may not use the Standing Liquidity Facility as growth of deposits has been very slow. Liquidity in the banking system remained at a surplus of around $2.75 trillion with yields of short term CP and CD flat and largely lower.

Data also showed M3 for the fortnight ended May 12 rose 0.6% with a largish rise in the currency with the public. At a rough estimate, currency with the public now is close to 84% of the holdings in pre-demonetization week. Consumer demand and consumption should remain robust.

Profit taking should see some upward movement in yields of benchmark bonds and a move towards 6.85-6.90 in the new benchmark paper should trigger buying interest.

The writer is executive director, Lakshmi Vilas Bank