The rally in bond markets continued unhindered driven by foreign fund purchases, despite dimming possibility of monetary policy easing at the Reserve Bank of India’s quarterly review next week.

The fund buying pushed up the 10-year benchmark security, (the 8.79 per cent falling due in November 2021) prices up to Rs 104.23 (face value Rs 100), last weekend. The price translated into a yield of 8.15 per cent. The previous week the security had ended at Rs 103.76 (8.22 per cent).

Despite rapidly firming bond prices or softening yields, cash in the banking system stayed in a severe deficit mode. At last Friday's Liquidity Adjustment Facility Auction, banks borrowed Rs 1.51580 lakh crore or about 2.6 per cent of the aggregate deposits. The high borrowing was despite the open market operation that infused Rs 10,535 crore.

The cash crunch was largely driven by the foreign institutional investor bond buying. Absence of RBI intervention in the markets to purchase dollars resulted in shortage of cash, traders said. The cash shortage also kept the collateralised borrowing and lending obligations market elevated. CBLO, interbanking borrowing/lending of cash against collateral, rates were 8.52 per cent.

Yet few expect, the RBI to cut the cash reserve ratio (CRR). The CRR is a zero interest balance that banks maintain against their deposits. Bank of Baroda's chief economist Rupa Rege Nitsure said, “The pressure of inflation has not abated. So it is premature to expect any drop in rates or liquidity easing now.”

Domestic rating Agency CARE’ report on the outlook for the economy also had similar inferences. The report said, “The RBI may prefer to use OMOs as a CRR cut is viewed as being rather permanent, as a part of policy stance and reducing the same could send contradictory messages to the markets. The RBI has been following an anti-inflationary policy stance since early 2010.”

However, global rating agency, Fitch Ratings differed and said that monetary easing could begin in financial year 2013 onwards if inflation eases to 7 per cent The Fitch Report said, “If this (inflation easing to 7 per cent) takes place according to expectations, it not only means that the RBI can stop the monetary tightening process, but it should also be able to begin to reverse course and start the process of monetary easing within 2012. Although it is unlikely that the RBI will be able to bring its key repurchase rate back down to the 5.0 per cent-6.0 per cent range that existed in 2009, it may be able to implement cuts of around 100 basis points during Financial Year 2013.”

Bond markets though were driven by different dynamics. Traders said that FIIs were yet to fully utilise the $15 billion dollar limit for investments in government securities. Besides, the Euro has become the new vehicle for carry trade. Carry trade implies borrowing in Euros and arbitraging the same in high yielding instruments. Since equities are not fully favoured at the moment from risk averse investors, sovereign debt was the preferred investment instrument, the traders said.

The Euro’s emergence, as a carry trade vehicle, started after the European Central Bank conducted two Long Term Refinancing Operations (LTRO) that were flooding global banking system the equivalent of ¤2 trillion of cash. This cash was finding its way into emerging market debt, traders said. Not surprisingly, most sovereign debt purchases under the FII limits were from European banks.

The benefits of the European induced cash flowing into the domestic markets helped the domestic government borrowing auctions at last week’s auction. Bids for the Rs 14,000 crore sovereign bond auctions was 2.3 times more than what was offered, pushing up prices or pulling down yields. With this round of borrowing, the government has borrowed Rs 4.38 lakh crore or 86 per cent of its enhanced borrowing target

Dollars however, remained in short supply in the domestic markets. Demand from refineries and power-generating companies remained overwhelming. Energy companies have also begun taking forward cover, anticipating that there could be another round of exchange rate correction in the near term, as oil prices remained firm. India’s import basket price is presently $113 a barrel.

Hedging by energy importers pushed up premiums sharply. One month forward premium are at a 10 month high of 9.63 per cent. But the foreign cash inflow is likely to continue for some more time. That trend was evident was from the non-deliverable forward (offshore trading in rupees where settlement is in dollars). The one month dollar was cheaper by almost 40 paise in the off shore market an indication that some near term firming of exchange rates was imminent.