Oil Spike to $100 May Weigh on Indian Bonds, Reversing Gains

Indian government bonds are likely to face selling pressure in early trade on Wednesday, as a surge in global crude prices to near $100 per barrel revives inflation worries. The yield on the benchmark 6.94% 2036 bond is expected to move in a range of 6.94% to 6.98%, after closing at 6.9431% in the previous session.

Traders had been building optimism that the central bank would avoid aggressive liquidity tightening, but the sharp rise in oil prices has dampened that sentiment. "The positive momentum about no stringent liquidity absorption is being offset by the oil spike," a trader at a private bank said.

Brent crude has climbed for a fourth straight session, following fresh Iranian attacks on U.S. military assets in the Gulf. Iran's Revolutionary Guards said they targeted two U.S. destroyers and a base in Jordan with ballistic missiles, in retaliation for U.S. strikes on Iranian oil tankers. The U.S. has warned of continued retaliation.

A sustained rise in oil prices could worsen India's inflation trajectory and strain government finances. The central bank has so far used overnight variable-rate reverse repos to absorb excess liquidity, rather than selling bonds. Banking system liquidity has hit a record high due to large diaspora deposits, which if sustained could fuel inflation and asset price bubbles.

Overnight indexed swap rates are expected to inch higher in line with bond yields. The one-year rate ended at 5.95%, the two-year at 6.1350%, while the five-year rate fell to 6.43%.