Demand for bonds should support lower yields

Markets across the globe witnessed lacklustre trading last week as fund managers and economists keep debating the poor pickup in both demand and inflation despite continuous excessive policy accommodation for almost half a decade by major central banks.

We saw a few policy decisions by central banks during the week which were on the expected lines. Among the majors, ECB left both rates and liquidity measures unchanged and put to rest rumours that a taper was on the anvil. US data showed signs of further strength but the larger focus is on the November elections. The third and final round of presidential debate ended and now the world's largest economy braces for a momentous verdict. The odds of a December hike keep growing, nonetheless. Brazil cut rates for the first time in four years as the country struggles to recover from one of the deepest recessions on record.

Tracking mild rise in US Treasury yields, domestic bond market opened on a bearish note. Though market fundamentals continue to remain positive, traders' approach suggests caution due to uncertainty over liquidity conditions as FCNR repayments gather steam. While stock market went through a roller coaster ride on a few days, the biggest disappointment was the impasse over GST implementation, as the third round of council meetings failed to make headway.

Otherwise, tighter money market conditions, negative liquidity and slightly firmer tone to bond yields characterised the week. System liquidity is negative in the mid-20,000 cr (measured by net of Repo and Reverse repos and excluding Call and CBLO) and short tenor money market yields closed tad higher. Bond yields ended a few bases higher w-o-w. Bond auction on Friday went off well with bid-to-cover in the higher 2s and no-devolvement, suggesting robust demand. The cutoff for long tenure bonds, however, was slightly higher. RBI data suggested a run down on reserves by a few billions. Maybe, to allay fears arising out of tighter rather negative net liquidity in the system, RBI announced two OMO auctions, for 24th and 25th, that should pump in 30,000 crore of liquidity. Spectrum payout and the ensuing coal auction could be factors to watch on the liquidity front as traders close in on the Diwali mood.

Looking ahead, Q2 results from major banks should guide market sentiments. While underlying demand for bonds should support lower yields, participants will prefer to watch the trajectory of US yields. On a related note, total bank deposits crossed Rs 100 trillion for the first time ever and data on trading of corporate bonds suggested an all-time high in volumes. While these augur well for the debt markets, the moot point is if this translates into solid credit growth.

The 10-year benchmark should trade in a 6.82-6.87% range (corresponding to 6.73-6.78% in the new benchmark security). Focus on liquidity conditions and Rupee movements will be dominant in the days ahead.

The writer is executive director, Lakshmi Vilas Bank