A rude shock awaited the bond market once it reopened after a two-day gap: the 10-year yield hit 7.25%, the upper end of the band that was expected to hold for the rest of the financial year.

What will be the next resistance?

What happens to the yields on corporate bonds and other instruments?

In all likelihood, bonds could see a massive surge in investments at the present levels, which could push down the yields by 10 basis points in the coming days.

The broader trading range of 7.10-7.25% can, however, move to 7.10-7.30% now that the 7.25% level has been breached. The narrower range could be 7.20-7.30%.

In an extreme case, the 10-year yield could rise to up to 7.37%.

The real test could be how the market bids at this week’s auction. Any demand for very high cutoff yields could lend upward pressure on yields, and they could settle in the 7.30-7.40% band on the 10-year.

Knee-jerk Reaction

Indian bond market was closed on Aug 15 and Aug 16 for Independence Day and the Parsi New Year.

There were two key developments since the markets closed on Aug 14.

First, July CPI inflation sped to 7.44% due to a surge in food prices. Second, the US Federal Open Market Committee’s July meeting minutes showed that rate-setters expect at least one more rate hike in the coming months. This had driven up the US yields.

India’s July inflation was much higher than even the most pessimistic market expectations. Most economists expected inflation to rise to 6.5% for the month.

Bond traders viewed that while inflation could come down soon with the arrival of fresh stock into the mandis and the government’s measures to boost the supply of cereals and vegetables (including imports from Nepal), the RBI will have to defer any rate cuts by several months.

By itself, the surge in inflation above the RBI’s target band of 2-6% won’t invite another round of rate hikes by the RBI; any persistence of inflation above the target band could force the RBI’s hand.

Moreover, bond traders are worried that the RBI’s imposition of an incremental cash reserve ratio, which is expected to drain ₹1 trillion from the banking system, will not be as shortlived as the central bank had promised earlier this month.

Tighter liquidity is expected to pressure the short-term rates and, consequently, even the long-term yields higher.

These three factors drove up the 10-year bond yield to 7.26% before it eased to 7.25%, the psychological level.

What Next?

Strong demand is likely to emerge on the view that the present level will be attractive for investments.

Long-term investors like insurance companies, provident funds and even some banks will step up investments at the present levels.

Investors could be reluctant to enter into short positions at the current levels expecting the market to be well bid at the present levels. This could ensure that sentiment will not drive up yields sharply beyond the present levels.

To that extent, the auction Friday will be the key. Good demand at the auction could drive down the 10-year yield to around 7.20% next week. But poor demand could incentivise traders to enter short positions and drive up the 10-year yield to 7.30%.

The intense action in the government bond market could turn the corporate bond market quiet. Many issuers could move to the sidelines waiting for a clear trend to emerge and gauge if the yield surge this week was a knee-jerk reaction.

Bond traders could also take some heart from some aspects of the inflation data.

While the headline inflation spiked, core inflation has eased. This means demand-driven inflation is not alarming, and the price rise was only due to seasonal factors, which could soon ebb.

The bar for the RBI to hike rates has eased somewhat, and the bar for it to cut rates has risen a bit. This does not mean that yields will have to rise sharply.

But a sharp fall in yields is also unlikely. This is because the government has lined up big borrowing till the end of September.

Yields could hold or ease if the government cancels one or two rounds of the auction in the coming weeks and defers them to the third quarter of the financial year.

The bond market will take a bit of time to settle down. But the yields will have an upward bias.