The investment bank has ruled out any sharp increase in credit demand for the next couple of months. Even bond issues from institutions are much lower than in the previous year, it said.

While dollar inflows will ensure comfortable liquidity in the banking system, sluggish credit demand (both by way of loans and new bond issuances) will see surplus funds with banks chasing government bonds, it pointed out.

Hence, government securities are expected to remain well bid with clear bias towards yields softening further from current levels over the next two to three months.

After being fairly range-bound between October 1998 and February 1999, yields on government bonds have declined quite sharply. The drop in yield on the benchmark 10-year government bond has been over 35 basispoints over the past three months. The softening in yields for medium maturirites (five years) has been even higher at about 60 basis points during this period.

Moreover, this decline in interest rates has come even when supply of government debt was fairly high on account of the new years' borrowing programme. The foreign reserves have risen sharply by over $3.5 billion since October 1998. The money supply has been closely tracking the accretion in foreign reserves over the past six months. Of the $3.5 billion accretion to foreign reserves since October 1998, inflows through the external commercial borrowings (ECBs) have been particularly strong at $1.88 billion.

During the period, the foreign direct investment (FDI) is estimated at $750 million and net foreign institutional investment (FII) and global depository receipts (GDR) inflows at another $750 million. Whether these dollar inflows can be sustained will determine to a large extent how far the bull run in bonds and in forex forwards willcontinue, the report said. During this period, the contribution of forex reserves to the reserve money creation has been nearly twice as much as the contribution from net RBI credit to the central government.

Another factor working in favour of the interest rate markets is the stronger deposit growth with banks relative to credit off-take. Credit growth between October 1998 and mid-January 1999 was very strong matching deposit accretion and leaving no investible surpluses with banks. On the other hand, deposit growth has accelerated sharply since mid-Janaury (driven primarily by forex flows) and at the same time credit pick-up has dropped resulting in flow of funds to government bonds.

The two most important variables driving interest rates lower over the past couple of months have been the strong dollar inflows and poor credit off-take. These are likely to remain the most important parameters affecting interest rates in the next few months as well.

According to the JP Morgan report, the foreign inflowsaided to a certain extent by the improved sentiment towards southeast Asia are quite broad based and unlikely to reverse in the short term.

There are over $1.5 billion ECB approvals which could result in inflows in the near furture. Hence, though the dollar inflows may not be able to match the pace seen since January, they are expected to remain strong for the next few months. This will result in adequate money supply growth and sufficient liquidity in the banking system, the report said.