Bonds give up gains as inflation reality dawns

After two days of intense rally, the domestic bond markets took a break moving into a consolidation phase.

In the last two trading days, the yields on the government bonds fell 58 basis points, or 0.58%, to close at 6.87% on Monday. But on Tuesday, the yields went four basis points to end the day's trade at 6.91%. Moody's rating upgrade triggered the rally on Friday which was augmented by the Reserve Bank of India (RBI) when it cancelled the open market operation (OMO) for selling bonds worth Rs 10,000 crore to mop up excess liquidity citing "evolving liquidity conditions".

The cancellation of the OMO was a signal to the market that the central bank would not tolerate yields beyond 7%, considering that the repo rate is at 6%.

"Yields did fall sharply after the credit rating upgrade, but there was apparently some heavy selling by some mutual funds and few others which pushed the yields higher and triggered some stop losses. Reasons for the rating action were priced in by the government securities market. As far as the OMO decision is concerned, it was felt by the market that these should stop, given the liquidity situation, helped the sentiment significantly," said C Venkat Nageswar, deputy managing director in charge of global markets, State Bank of India (SBI).

OMO can be bond purchase or bond sale operation depending on the liquidity in the market used by the central bank to balance out the liquidity in the market. It has absorbed more than Rs 90,000 crore of liquidity from the markets neutralising the excess money floating in the system.

"The big rally all through the last two trading days was first due to Moody's rating action followed by the Central bank cancelling the bond auction," said Bhaskar Panda, senior VP, treasury, HDFC Bank. He said that banks and mutual funds were the most active participants in the rally. Banks, he said, would have booked considerable profits in the last two days, but would be difficult to say if the gains would remain until the banks announce their third quarter results next month.

"The rupee closed quite strong on Tuesday with a good bit of selling from the corporates. For the past one week, there was plenty of hedging from the importers and on Tuesday finally the exporters stepped into the market. We expect the rupee to remain around Rs 64.70 to Rs 64.80," said Anindya Banerjee, deputy vice president - currency and interest rates, Kotak Securities.

Dealers with public sector banks say that the rally is over now that there will be consolidation from here on. They believe there is only going to be a 0.5% movement, either up or down. And rupee will also hold to the existing levels. On Tuesday, the benchmark government bond is up two basis points, closing at 6.91% about 4 basis points higher than the previous day's close. On Monday, the yields had ended at 6.89% for the benchmark bond.

The total rally on the 10-year benchmark government bond for November 20 and November 17 was nearly 21 basis points or 0.21% down from the 7.10 % levels early last week.

"But now, the reality is striking the market. The rising inflation due to erratic food prices, a stubborn Reserve Bank of India unwilling to let go its guard on inflation and concerns about the fiscal discipline are all going to weigh on the market, " said a head of treasury at a public sector bank.

"Rupee closed higher on Tuesday as foreign banks sold dollar and local shares gained, boosting expectations of overseas fund inflows. However, oil importer-related greenback bids limited further gains in the rupee. The pair ended at 64.89, against 65.11 at close on Monday," said a a report from IFA Global, a Mumbai-based currency research firm.