Gilt traders look for Fed cues

Government bond yields slumped today, a day after the Reserve Bank of India hiked its repo tender rate and dropped ample hints of persistent monetary tightening in its attempt to curb inflation.

Bond traders, ironically, are drawing comfort from US Federal Reserve, which is expected to slash interest rates from early next year, as a string of data releases there have been pointing to an economic slowdown.

Today, the 7.50%, 2034 bond fell to 8.03% from 8.10% Tuesday. The benchmark 10-year yield ended at 7.61%, against 7.62% Tuesday.

"If there is 4-5 basis points rally in US bonds in the next few days, there can be a substantial increase in local gilts," said a dealer at ICICI Securities.

Ten-year US yield fell by 6 basis points to 4.61% on Tuesday, after consumer confidence data for October strengthened hopes of rate cuts by the Fed.

"If the Federal Reserve starts slashing rates, he (Governor Reddy) won't be on a single trajectory to hike rates," said head of a primary dealership founded by a foreign bank.

Despite the hawkish tone of the monetary policy, gilt dealers believe that RBI's rate hike cycle may be peaking out.

Hawkish stance ignored
Gilt dealers said the market wasn't worried about the hike in the repo rate.

"Perhaps, our management is more worried after the policy. We aren't too worried now about the yields," said a dealer at a private bank.

While all eyes were on the reverse repo rate, the RBI hiked the repo rate with a view to force banks to curtail loan disbursements.

RBI has been raising interest rates since October 2004. Its reverse repo rate was hiked six times in the last two years. Despite this, the RBI said, signs of overheating of the economy couldn't be ruled out at the current juncture.

However, bond dealers said absence of a hike in the reverse repo comforted traders on Tuesday.

"By not raising the reverse repo rate, RBI has protected the sentiment in the gilts market," said Rupa Rege Nisture, chief economist at Bank of Baroda.

"We should not read too much into the repo rate hike as it is just an adjustment of the corridor. Liquidity is under pressure but RBI is also opening up offshore money into India. It's not that gates have been closed on liquidity," said J Moses Harding, executive vice-president, IndusInd Bank. Repo rate hike was expected to hurt only if liquidity tightened, he added. Most dealers said that liquidity would improve by end of November once the government stepped up investments.

"The market is neutral to the policy. Yields have been flat. The only thing the market has reacted to is the liquidity front," said Suresh Prabhu, chief dealer at HDFC Bank.

"Liquidity has been under pressure. We will see the actual reaction once liquidity improves," he added.

SLR Requirements
According to dealers, banks' need to shore up their bond reserves will keep demand for gilts high in the coming days. The RBI has been asking banks to boost their deposits to keep pace with their credit growth. Banks' efforts to boost deposits will as a consequence lead to their stepping up investments in gilts to meet their Statutory Liquidity Ratio (SLR).

Several banks, including some state-owned banks, are on the margin in terms of meeting their bond reserves. Banks' credit-deposit ratio was at 72% as of October 13, up from 67% a year ago.

Yield curve
Gilt traders got a shot-in-the arm from RBI's Deputy Governor Rakesh Mohan's approval of the slope of the yield curve Tuesday. Earlier, there were worries that RBI might attempt to drive up the long-term bond yields in view of the growing economy as the yield curve had become flat.

Mohan said that the RBI and the market were on the same wavelength on the medium-term view for inflation, as reflected by the slope of the yield curve.

The spread of 10-year bond over a 1-year Treasury bill has shrunk to 61 bps from 130 bps in early August.

Mohan's comments raised hopes of the market being priced correctly in the evolving economic developments.

Going forward yields are likely to react more to US economic data and interest rates. For the coming months, bonds are expected to have a downward bias. Only tight liquidity conditions may keep them firm in the intermediate period.