Bonds rallied after a break, backed by foreign fund purchases and supported by the Reserve Bank of India's (RBI) resumption of cash infusions into the banking system.

The price of the benchmark security, the 8.79 per cent 2021 falling due in November 2021, firmed to Rs 104.36 (face value Rs 100) over the weekend, translating into a yield of 8.13 per cent. In the previous weekend, the price of the security was Rs 103 or a yield of 8.33 per cent. The price of the security firmed after RBI reinstated its open market operations (OMO).

OMO, or purchase of securities by RBI, resulted in infusion of another Rs 8,900 crore into the banking system. With this, the cash infusion amounted to a little over Rs 1,10,000 crore, inclusive of Rs 32,000 crore through a reduction in the slice of deposits that banks are required to keep with RBI. These deposits with RBI don’t earn any interest. But OMOs also removed some securities from banks that could impact their overnight borrowings from RBI through LAF (liquidity adjustment facility) -- RBI's window for cash infusion through repurchase of securities. Canara Bank's fixed income head Suresh Pai said, "The operations have helped bonds and there will be more supply of government papers in the market for meeting our needs." The reference was to more borrowings by the government in the coming weeks through issue of dated securities and treasury bills.

That liquidity injection helped bonds was evident from the response to the government borrowing auctions at the weekend. Bids amounted to 2.28 times the offered amount of Rs 13,000 crore. With this round, gross borrowings through dated securities this year so far amounted to Rs 4.64 lakh crore or 91 per cent of the revised target. That means the government is likely to borrow just Rs 48,000 crore more during the remaining part of this financial year.

However, cash deficit remained acute. Overnight borrowings through LAF auction was about 2 per cent of the aggregate deposits of banks, well above the central banks’ comfort level of 1 per cent. In the inter-bank collateralised borrowing/lending obligations market, rates were at 8.87 per cent or well over the RBI overnight cash support rate of 8.5 per cent.

The cash deficit was partly on account of the foreign exchange inflows into the domestic market through foreign funds. Foreign fund inflows in the first three days of February alone were $ 1.11 billion, according to data from the Securities Exchange Board of India. Traders said that the flows were largely driven by two currencies, Euro and Dollar, vying to become vehicles for global carry trade. Under the long-term refinance operations, the European Central Bank provides cash at just one per cent.

The US Federal fund (inter-bank borrowing/lending of reserve funds) is available at just 0.25 per cent. Yields in India, even after factoring a risk premium $3,00,000 for a $10 million cover, appear enticing for foreign investors, a key factor supporting the inflows.

Since the inflows are far in excess of the open market operation, cash remained in deficit in the domestic banking system, traders said. But more inflows are expected by way of external commercial borrowings. After a long lull, Indian borrowers returned to the foreign currency borrowing markets. In December 2011 alone, inflows through foreign currency borrowings amounted to $ 4.5 billion.

Although oil prices have stayed put above $110 a barrel, with little signs of retreat, the capital flows have fired up the sagging rupee. Rupee has gained a little over 8 per cent from the lows it hit in December.

It could move a little higher. Signs of that were evident from the non-deliverable forward trades, an offshore market for non-convertible currencies where settlement is in dollars. Rupee was quoted at Rs 48.68 to dollar or about Rs 1.20 cheaper than the domestic one-month rates. Rupee is headed for a roll in the coming weeks.