Range-bound with upward bias

B. Venkatesh

BOND dealers have been a happy lot during the last fortnight.

Government bonds rallied at the long-end by around 20 basis points (bps). The rally has flattened the yield curve, leaving the term-spread between one-year and 10-year bonds at less than 100 bps. Going forward, what lies in store for the bond market in the coming fortnight? Bonds are likely to remain range-bound with an upward bias.

Consider the reasons for the upward bias. First, the economic data released recently suggests that the country has performed better than expected; the GDP growth rate for the second quarter was 6 per cent against 5.7 per cent in the corresponding period last year. Further, the balance of payments deficit has been reduced to $413 million from over $1 billion in the previous quarter.

Second, close to 90 per cent of the government borrowing for this fiscal has been completed. Even after accounting for the revenue slippages, the primary government bond offers may be few in number during the rest of the fiscal. With the credit offtake from the private sector yet to pick up, banks may use their funds to buy government bonds in the secondary market, creating the upward bias.

Having said that, it is not as if the bond market would witness another sharp rally. This is because of the following factors:

First, as mentioned earlier, the term spread is down to less than 100 bps. This leaves limited scope for rally, unless short-term yields fall further. But that is unlikely to happen any time soon, considering the tight liquidity position. Consider this. Tier I refinance at the bank rate has been drawn to the tune of Rs 10,228 crore as on January 4, 2000. Besides, the RBI has had to inject money into the system through reverse repos.

True, the liquidity position may ease a bit in the coming fortnight on account of coupon and redemption inflows of Rs 3,000 crore. But, that is unlikely to cause a sharp rally in short-end yields.

Second, real yields are too low for bonds to rally further. At present, inflation is running at around 8 per cent. If inflation expectation is assumed at the same level, real yields are less than 3 per cent for even a 10-year bond.

In the light of these factors, bonds are likely to remain range-bound with an upward bias.