Relief rally in bonds

Rather surprisingly, contradicting the predictions of most market pundits, the bond market has been seeing a smart rally, in spite of the Reserve Bank of India raising its reverse repo rate in its April monetary policy.

The yield on the ten-year government bond has fallen from around 7.25 per cent a month or so ago to 6.85 per cent on Wednesday morning, when bond prices climbed to near two-month highs.

This behaviour of the bond market is in marked contrast to the bearishness of the market after the RBI hiked the reverse repo rate to 5 per cent.

If the objective of the central bank was to lower inflationary expectations by pre-emptively raising the reverse repo rate, then it seems to have been amazingly successful in its objective.

However, the matter may not be as simple as that. The yield curve in the Indian market tends to merely reflect liquidity, and a hike in short-term rates raises yields across the curve.

Currently, however, long-term yields are lower than what they were just before the announcement of the monetary policy.

There are several reasons for the rally in bond prices. First, it's worth noting that bond prices have been rallying across the world, and the yield on the US 10-year Treasury note is at a three-month low, even as US Federal Reserve officials say that more rate hikes are round the corner.

More importantly, crude prices have cooled considerably, with the result that inflationary pressures have eased. The domestic bond market now believes that the government will be able to get away with a far lower hike in fuel prices than was expected earlier.

Bond market dealers also cite the fact that the inflation rate will be lower because of the base effect, which is expected to last till September.

But then, that fact has been known for quite some time, and should have been discounted by the market. The fact of the matter is not only that lower fuel prices have dampened inflationary expectations, but that sentiment in the bond market has improved substantially.

One reason for that has been the higher success rate in the state auctions, and the profits which those who participated in those auctions have made.

That in turn has increased the appetite for risk among market players. Increased liquidity with banks has been another factor, as credit offtake usually dips at this time of the year.

Hopes of higher liquidity have also been fanned on the stories about an impending revaluation of the yuan, which is expected to push the rupee up and lead to increased portfolio inflows into the country.

Liquidity has also been augmented by demand from insurance companies""the Life Insurance Corporation of India subscribed to the entire stock of 17-year paper offered at Tuesday's auction.

Moreover, companies too have returned to the government securities market, thanks to their increased liquidity as a result of being permitted to participate in repos/reverse repos.

Matters have also been helped by soothing words from the finance minister, who has talked about lower government borrowing.

It's likely, however, that the current rally is a temporary one, and the fundamentals of higher global interest rates, a high credit-deposit ratio and high government borrowings will soon re-assert themselves. Till that happens, however, it's a welcome relief for bond investors.