The rally in bonds lost steam towards the fag end of the 2011 as markets were stunned by the sharp increase in short-term borrowings for the fourth quarter of the financial year.

The announcement of short-term borrowing of Rs 1.52 lakh crore through treasury bills, pulled down the 10-year benchmark bond, of 8.79 per cent coupon falling due in Nov 2021, to Rs 101.47 (face value Rs 100). At this price the yield on the security translated to Rs 8.56 at the weekend. In the previous week the security was priced at Rs 102.75 or 8.37 per cent. The fall pushed it above the Reserve Bank of India’s overnight cash support rate of 8.5 per cent.

Traders said while the slippage in the government’s long-term borrowings by Rs 40,000 crore was already factored in, it was the treasury bill auction amount that actually caught the markets by surprise.

A trader, when asked what would happen to short term term yields, said, "Commonsense is that T-bill yields will rise in the fourth quarter."

However, it is a different story for long term yields.

IndusInd bank's executive vice-president Moses Harding said: "Yields will stay range-bound. We are not like to see any significant hardening in yields." He said supplies of government securities would be neutralised by risk aversion among banks in lending to commercial sector. At present, the banks’ holding of government securities is about 6-7 percentage points above their statutory requirements of 24 per cent of the deposits.

Paradoxically, the hardening of yields comes after a slight relief from the cash squeeze in the banking system. Overnight borrowings from RBI stayed high at Rs 1.1467 lakh crore or 2 per cent of the aggregate deposits. Early last week overnight borrowings had reached as much as 3 per cent of the aggregate deposits. The easing of the cash crunch also showed up in the inter-bank collateralised borrowing and lending obligations (CBLO) markets where rates fell below the RBI's cash support rate to 8.10 per cent.

The relief in cash was provided by the return of advance tax receipts back into the banking system and the absence of significant interventions in the foreign exchange markets by RBI during the week.

But yields are not expected to firm up significantly beyond present levels. A foreign bank trader said risk aversion remains firmly embedded in the market. The aversion manifested in the restrain in the credit growth. Non-food credit offtake remained low. This year so far non-food credit offtake was at least Rs 80,000 crore lower than the corresponding period of last year.

Kotak Mahindra's chief economist Indranil Pan said, "With credit not growing, the surplus funds were moving into government securities." Investments in sovereign bonds this year so far was 38 per cent of the incremental deposits collected this year. Only refineries, power utilities and commodity importers continued to draw down on their working capital limits for meeting their payment obligations.

As a result foreign exchange demand stayed high. That kept dollar prices at Rs 53.44. But traders said that dollar supplies in the markets were beginning to flow partly from the easing of non-resident deposit rates. With NRE deposit rates above 9 per cent, non- residents were beginning to move their overseas deposits into the country taking advantage of the interest rate differentials. Dollar deposit rates in the US barely fetched one per cent for one year.

Outflows are expected to be large, traders said. The outflows were in the form of payments for energy imports. Besides debt service payments this year alone was estimated at $18.5 billion. Other than NRE deposit flows, other capital flows stayed weak and are unlikely show any significant pick-up. RBI's Financial Stability Report released 10 days ago said, "The impact of risk aversion due to downward risk to economic and financial conditions in the US and Euro would be critical, particularly for FII (foreign institutional investor) flows to India."

One-month forward premiums stayed firm at 8.28, reflecting weak inflows in the next few days and high import outflows.

Banks’ risk aversion and weak dollar inflows also showed up in credit default swap (CDS) premium. CDS or over the counter bond insurance premiums are presently $4,50,000 for a $10-million exposure. The other indicator, non-deliverable forward (off shore trading in Rupee where settlements are in dollars) the rates remained at Rs 53.35, indicating weak markets.