A small bond rally likely in the near-term

B. Venkatesh

WILL bonds rally in the coming fortnight? That is the question passing through every bond dealer's mind now.

If one were to base the answer just on the liquidity factor, there appears some rally left in bonds.

Consider this. The 50 basis-point cut in cash reserve ratio (CRR) will be effective this fortnight, injecting about Rs. 3,500 crores into the banking system.

Then, there are inflows of over Rs. 2,000 crores from coupon payments. Besides, there are bond redemptions worth over Rs. 1,500 crores.

Further, there is the refinance facility that banks can avail from the Reserve Bank of India (RBI).

With only about Rs. 4,000 crores withdrawn till date, banks can still avail refinance of about Rs. 9,000 crores at bank rate of 7 per cent. Then, there is the tier II refinance at bank rate plus 2 per cent.

And, finally, the call market; call rates are currently ruling at around 6 per cent. Banks can, thus, borrow in call and invest in bonds given the positive carry.

All these factors allay fears of any liquidity strain on the system on account of the bond auctions this fortnight; the RBI has scheduled auctions for 5-year and 20-year bonds totalling Rs. 3,000 crores each. Besides, state government loans worth Rs. 7,000 crores would be auctioned on April 25.

Capping any large bond rally, however, may be market uncertainty on two fronts.

One, the uncertainty on interest rates. Such an uncertainty stems from reports that inflation may have bottomed out for now. This may lead to higher inflation expectations, prompting the market to demand higher yields on bonds.

And, two, possibility of demand for credit outstripping supply. The government is estimated to borrow Rs. 1,17,000 crores this fiscal. Not a problem except that demand for credit from the private sector also appears to be picking up.

An indicator is the rise in the incremental credit-deposit ratio of banks. That means banks are increasingly deploying their resources in creating loan-assets than in the previous years. At some point in time, government bond yields may have to rise for banks to start investing more in bonds.

Of course, it needs to be mentioned here that the two factors responsible for market uncertainty is subjective whereas the liquidity factor is more tangible. And that may lead to a small bond rally in the near-term.