A short rally likely

B. Venkatesh

BONDS have been wobbly yet again.

They first rallied, albeit marginally, on news that the US Government proposed to release oil from its strategic petroleum reserve. Thereafter, most of the gains were erased as the rupee trended downwards against the dollar.

Amidst such wobbly trends, what lies in store for the bond market in the coming fortnight? The bond market may witness a short rally on account of the ample liquidity in the system.

Consider the factors. In the auction held on September 28, for eight-year bonds, the Reserve Bank of India (RBI) received bids for Rs 4,030 crore against a notified amount of Rs 3,000 crore.

Further, about Rs 8,600 crore is still outstanding in repos. All this, even after 21 State government loans for Rs 2,106 crore were oversubscribed at an auction held on September 26. Besides, the inflow of Rs 6,000 crore into the system from a bond redemption has strengthened the banks' liquidity position.

With banks flush with liquidity, more money is likely to flow into the bond market. This is because banks may not find repos very attractive any more what with the RBI gradually cutting the repo rate to 10 per cent.

Capping the upside, however, is the concern on inflation; inflation has already inched up 1.4 per cent for the week-ended September 9. With the government all set to hike petrol prices, the fuel component of the Whole-sale Price Index will rise, pushing inflation further up. This may prompt bond investors to demand higher yields to protect their `real' return.

Then, buoyed by the response at the eight-year bond auction held on September 28, the RBI may schedule more bond auctions to raise finance for the government. Since it is the easy liquidity in the system that is likely to drive up bond prices, the RBI draining liquidity through bond auction may, needless to say, arrest any sharp bond rally.

And, finally, the volatility in the forex market is yet to come to a rest. Should the rupee once again trend sharply downwards against the dollar, the RBI may adopt interest rate or other measures to arrest such fall. The fear of any such RBI measure is likely to cap a sharp bond rally.

In all, while the ample liquidity in the system may cause a bond rally, concerns over inflation and rupee-dollar rate may cap the upside.