Yields may test recent highs, surpass 6.70%

The week that went by saw two major international political developments that rattled markets. Brazil and the US were in news for different reasons.

Equity markets in the US dropped 1.8% on Wednesday – the largest daily decline in nearly six months – in response to increasing turmoil in Washington. However, global indices ended the week flat after mid-week choppiness. The yield on the 10-year US Treasury note fell to 2.23% from 2.34% a week earlier while crude prices rose mildly amid signs OPEC and major producers such as Russia will retain output curbs through March of 2018.

UK prime minister unveiled the Conservative Party manifesto on Thursday, ahead of June 8 General Election. On Brexit, the manifesto says that no deal is better than a bad one and that the UK would seek an agreement with the European Union that would take the UK out of the single market and customs union but continue closer trade. In Brazil, the president was subject to allegations of collaborating in a major corruption scandal and in the wake of the allegations and calls for impeachment, stocks and the Brazilian real both plunged on fears the recent economic rebound could stall amid fresh political uncertainty.

Indian markets started on a cheerful note following data release in the previous week that showed lower inflation readings. Alongside an optimistic monsoon forecast and passage of the goods and services tax (GST) structure, which promises lower tax slabs for essentials and food articles, the newly issued benchmark rallied 17 basis points before some profit taking cooled the bullish bias. Going by market action and the rally at the longer end of the bond curve, one suspects more flattening to come in the days ahead as easy liquidity and dissipating fears of inflation-overshoot might be overwhelming.

The rupee weakened sharply for the first time in two months as strong foreign portfolio outflows triggered dollar buying against the rupee. At a time when the US dollar has been weakening against majors, the rupee has held rock steady and has gradually appreciated on the back of strong flows into both equity and debt. With rupee liquidity abundant in the system, the RBI may be more than happy to sell dollars (with reserves above 375 billion, there could be comfort) to stem the depreciation and also suck excess rupee liquidity.

RBI has been regularly conducting repo and reverse-repo operations. Net system-level liquidity continues to be above Rs 3 lakh crore. Cut off for Tbills came a tad higher while for the regular bond auctions, the cut offs came nearly on expected lines. Bond yields rose after auction results.

With data calendar light this week, the default play of carry should favour bonds. Minutes of the May Federal Open Market Committee could help understand how aggressive the US Federal Reserve dot-plots are. The new 10-year benchmark should test its recent highs and therefore yields may range in a 6.60-6.75 range in the weeks ahead.

The writer is executive director, Lakshmi Vilas Bank