Why were the markets suddenly awash with funds? The latest issue of government securities was through the private placement route (Rs 2,500 crore); furthermore, the OMO window was inactive. However, these factors are inadequate to explain the extent of liquidity. Our hypothesis is that RBI's activity in the currency market released rupee liquidity during the week.

Comfortable levels of liquidity could permit call rates to fall sharply this week. The key factor is whether there would be another auction this week. In the absence of an auction, call rates could drop sharply. We expect call rates to be below 8 per cent this week.

Rupee trades between 43.20/$ and 43.27/$

The rupee showed signs of appreciation at the beginning of the week and tested43.20/$ levels. However, demand for dollars emerged towards the end of the week and the rupee closed at 43.27/$. Strong receiving interest drove forward premia lower. One-month, three-month, six-month and one-year premia closed at 3.8 per cent, 3.9 per cent, 4.3 per cent and 4.65 per cent respectively.

182-day T-bill cut-off yield falls

The 182-day T-bill cut off at 9.91 per cent, five basis points below the previous auction. The cut off yield for the 14-day treasury bill was also lower at 8.11 per cent, eight per cent of the 91-day bill auction devolved on RBI while the cut off yield was lowered to 9.27 per cent.

Bullish sentiment props up gilts

Speculation of reduction in CRR and bank rate dictated markets last week. Gilt prices ran up sharply, with the maximum price appreciation at the medium to long end. Easy call rates have led to yields dropping sharply at the short end. Currently, the yield curve is steep till the five-year segment, the yield pick-up is about 10 bps per year.Yield differential between two year and ten year securities have widened to over 100 bps.At this time, the potential downside is restricted to the government borrowing programme. Market sentiment is positive and incremental liquidity is like to be invested in medium to long end securities chasing "carry". We concentrate our recommended portfolio towards the long end. We also bias the portfolio at the five-year segment to take advantage of the yield curve kink at that point.

Corporate paper

Secondary activity picked up sharply in the CP market as calls declined below 8 per cent levels. Yields declined by 10 bps, with 3, 2 and 1-month rates settling at 9.85 per cent - 9.90 per cent , 9.65 per cent - 9.75 per cent and 9.35 per cent - 9.50 per cent. With short-term liquidity outlook being positive we expect further upside in CP market over the next fortnight. Issues by FIs have set the 3, 5-year yields at 12.25 per cent, 12.50 per cent respectively. With one and two year secondary yields at 11.25per cent and 11.75 per cent, we expect 10-15 bps upside in the 3-year maturity segment.

(For the week ending July 31)