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The headline numbers of government fiscal deficit belie the underlying reality. On the face of it, a reduction in fiscal deficit from 6.8% of GDP in 2009-10 to 5.5% of GDP in 2010-11 looks highly positive for bond markets.

The gross and net market borrowings of the government at Rs 457,000 crores and Rs 345,000 crores, respectively, are also positive for yields because the market was expecting higher numbers.

Yields should have ideally rallied on the announcement of the fiscal deficit and borrowing numbers.

In fact, ten-year yields did rally from pre-budget levels of 7.82% to 7.77% levels after the announcement of the deficit numbers.
However, they gave up all their gains to close at 7.87% levels on the back of underlying worries on inflation and supply.

The yields are likely to trend higher leading into April 2010 on the back of higher trending inflation expectations and supply-demand mismatch.

The government in showing a fiscal deficit of 5.5% of GDP has estimated a 20% jump in tax collection. The government has raised excise duties in items such as cement, auto, petro products etc to raise indirect tax revenues.

The higher excise duties is leading to higher product prices as manufacturers pass on the hike to the consumer.

Post-budget, refiners, auto and cement manufacturers raised prices to pass on the excise duty hikes. The higher product prices will take up inflation expectations. Inflation as measured by the wholesale price index (WPI) has already breached Reserve Bank of India's (RBI) end-March target of 8.5% and is currently standing at 8.56%.

Inflation is expected to touch double-digit levels in a couple of months on the back of rise in fuel and other product prices

The gross borrowing of Rs 450,000 crores will in all likelihoods be frontloaded. Supply starting April 2010 will be around Rs 12,000 crores to Rs 15,000 crores per week.

The supply will come in the face of higher inflation expectations and on expectations of policy rate hikes by the RBI in their annual monetary policy end April 2010.

The supply will not be tempered by the central bank's purchase of bonds through their open market operations given inflation conditions.

The RBI had, in fact, raised the cash reserve ratio by 75 basis points in its policy review in January 2010 in order to suck out liquidity to control inflationary pressures.

On the demand side banks will have to participate in a large way to absorb the supply and given that the system is holding more government bonds than is required (excess of at least 3% or Rs 120,000 crores) the demand may not bevery forthcoming given inflationary pressures.

The RBI has indicated that managing a government borrowing of the size of Rs 450,000 crores will be a tough task.

Post-budget statements by the RBI ruled out hikes in banks' statutory liquidity ratio which increases banks demand for government bonds. The RBI has also ruled out hike in held to maturity cap of banks which could have led to more purchases of government bonds by banks.

RBI may use tools such as open market purchases only if bond auctions threaten to fail or if yields shoot through the roof. Hopefully, by the time government bond supply commences the levels of yields may be attractive enough to create demand.

This will be the best situation for the market and will make RBI's task of managing the borrowing that much easier.

Views are personal.