For FII money to come in, investors need to be convinced that bond prices will rise in the future

High inflation, lower-than-expected open market bond purchases and fears that the government might not be able to curb the fiscal deficit have conspired to keep yields higher.

The yield on the new 10-year bond issued by the government is 8.7%, a reflection of demand for this particular security that will become the benchmark with more supplies. The existing 10-year benchmark continues to trade close to 9%, despite the central bank pulling back some of its exceptional tightening measures.

High inflation, which has prompted the Reserve Bank of India (RBI) to raise the repo rate, lower-than-expected open market bond purchases and fears that the government might not be able to curb the fiscal deficit at the promised number have conspired to keep yields higher.

Still, RBI governor Raghuram Rajan's statement to analysts after the last monetary review that "the central bank risks excessive monetary tightening given the lag in monetary policy" has led a section of the market to believe that the December policy may not see any tightening. It is also hoped that the central bank would completely wind down its exceptional tightening measures and the repo rate would become the operative rate.

The more immediate trigger, one that will either reassure or destroy investor hopes, would be the gross domestic product numbers that will be released on Friday. If the numbers beat market expectations, that would provide RBI some elbow room to hike rates further. In such a scenario, it is difficult to see bond yields come down.

Of course, there is also a possibility that banks may step up their government security purchases after receiving $18 billion through special windows to attract foreign currency deposits. As it is, credit growth has again declined after reaching a high in mid-September owing to high money market rates.

While that could drag down bond yields, there would not be much support from foreign institutional investor (FII) buying. Despite the gap between the Indian and the US 10-year yields widening to almost a 10-year high, FIIs have continued to pull out their money from Indian bonds. For FII money to come in, those investors need to be convinced that bond prices will rise in the future. That uncertainty will remain for some more time.

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