Inflation frays market nerves

Bond prices slump after inflation hits 5.9%.

Sharply higher inflation spooked the government securities market on Friday, with the yield on the benchmark 10-year paper rising to 5.90 per cent before ending the day at 5.82 per cent, its highest close in the last 13 months.

The yield, which has risen 36 basis points so far this week, last closed higher at 5.8278 per cent on May 22, 2003.

Bond price slumped after the official data released at noon showed the wholesale price index (WPI)-based inflation rising to a four-month high of 5.89 per cent for the week ended June 12, higher than 5.55 per cent in the previous week and 5.03 per cent on May 29.

There was, however, not much reaction in the very short end of the market. The yield on the 91-day Treasury Bill ruled at 4.45 per cent, and on the 364-day T-bill at 4.63 per cent.

The five-year bond price fell by 30-40 paise with the benchmark yield quoted at 5.5 per cent. The yield on corporate bonds too edged up and the spread of corporate bonds over government bonds narrowed marginally.

"With the rise in petrol and diesel price as well as higher coal prices, the inflation rate may go up further. It will add to the uncertainties over the outlook on interest rates," said a bond dealer. The market is expecting the 10-year benchmark rate to touch 6 per cent next week.

The crucial US Fed meeting next week will be the next trigger for the bond market, besides inflation data. A quarter percentage point rate hike by the Fed (to 1.25 per cent) has already been priced in. However, a further hike will lead to more selling in the bond market, a dealer said.

While there was virtually no trading in the longer term of the maturity for fear of registering losses in the portfolio at the end of the quarter, the medium-term bonds witnessed a fall of around more than Rs 1.50, especially in the 11 and 13 year maturity bracket.

The 10-year benchmark rated recovered after Ashok Lahiri, the chief economic adviser to the finance ministry, said, "The government is fully committed to price stability. Hardening of inflation was due to seasonal fluctuations and I don't think it will remain high. There will be a downward movement in the coming months."

The market is divided on the outlook of the bond market but there is a consensus on the fact that the inflation data has assumed more significance than the possibility of a base rate hike by the Federal Reserve.

"The 10-year benchmark yield has reached the peak and will settle around these levels and there will be a strong resistance to break the 6 per cent level. There will be a small recovery after the Federal Reserve hikes its rate, as a possible hike has already been factored in," said SR Kamath, general manager, Securities Trading Corporation of India, the leading primary dealer.

Partha Mukherjee, head of treasury, UTI Bank, said the market will be very volatile with the 10-year benchmark hovering in the range of 5.75-6 per cent. "Some kneejerk reaction is expected next week, when the inflation rate is likely to firm up further," he said.

"The 10-year is expected to move in the range of 5.75-5.90 per cent in the medium-term. While the Fed rate hike has already been factored in, inflation rate is affecting the market," said Amit Bansal, head of treasury at Barclays.

Although the bond yields are firming up, there is enough liquidity in the system to make the 10-year yield rule in the range of 5.50-5.75 per cent, said AS Khurana, general manager, treasury, Bank of Baroda.