Bond prices rally on hope of cash infusion into banks

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Bond prices rallied sharply during the week, as expectations of further infusion of cash into the banking system mounted, with the sharp retreat in inflation.

The rise in bond prices came despite the advance tax payment outflows. Advance tax outflows under normal conditions lead to cash tightening and falling bond prices. However, the price of the benchmark 10-year sovereign bond, the 8.15 per cent coupon, falling due in June 2022, rose to Rs 100 or on par with the face value last weekend. In the previous week, the security was priced at Rs 99.84 or 8.17 per cent.

The surge in bond prices was partly on account of the sharp drop in core inflation. Core inflation is a measure of price rise of manufactured products, excluding both food and fuel. This measure was down to a 32-month low of 4.5 per cent in November, which reflected the sharp slowdown in the manufacturing sector. Bank of Baroda’s chief economist, Rupa Rege Nitsure, said, “The drop in this measure means that the pricing power of manufacturing firms has dropped significantly, on the back of a demand slowdown.”

The slowdown also reflected in rising bond prices due to weak credit demand, especially investment credit. Yet despite the weak investment credit, overnight borrowings –– Reserve Bank of India’s repurchase window –– remained high. At the weekend liquidity adjustment facility auction, bank borrowing topped Rs 1.29 lakh crore or 2 per cent of the aggregate deposits. But traders said the surge in borrowings was partly because most banks preferred taking advantage of RBI’s window for meeting their cash requirements, given the high holdings of sovereign bonds.

Presently, holdings of sovereign bonds is about 31 per cent or 8 per cent more than the mandated statutory liquidity ratio that prescribes bank investments in sovereign bonds against their deposits. The high ratio allowed banks to leverage for cash of up to Rs 5 lakh crore from RBI window.

Yet despite the large overnight borrowing, cash conditions in the banking system remained comfortable as evidenced by collateralised borrowing and lending obligations market. Lending rates in the CBLO markets, where all institutions participate, remained well below 8 per cent (RBI’s repurchase rate).

Traders said the short-term demand for cash remained high in the market, partly for meeting working capital demand and retail cash demand for the festival purchase expenditure. Accordingly, RBI expected more short-term cash injection measures at its mid-quarter policy review on Tuesday, traders added. BNP Paribas Asia chief economist, Richard Iley, said, “A 25 basis points cash reserve ratio cut to address the persistently high tight liquidity appears likely.”

The demand for working capital also stemmed from oil companies for meeting their import payment obligations. Oil prices are pres­ently down to $107 a barrel. Commodity importers have also begun hedging their payment obligations to avert losses due to currency depreciation over the next three to six months.

Yet despite the increased hedging and foreign currency demand, the price of the dollar dropped in the non-deliverable forward markets (offshore trading in rupees with settlement in US dollars) to Rs 54.74 as against the domestic one-month forward rate of Rs 54.72. The narrow difference was a pointer that rupee exchange rates would remain range bound.

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