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FX forward points moved significantly to the right, which propelled THBFIX and concomitantly IRS rates north. Inflation concerns, with May and April headline CPI printing 7.6 per cent year-on-year and 6.2 per cent, respectively, underpinned the bearishness of late.

Meanwhile, heavy foreign inflows into the bond market persisted in May, particularly in the 5-year, on talk that offshore players were rebalancing portfolios amidst a recent reweighting of a global bond index, which partly attributed to bonds outperforming swaps.

Moreover, given that it is easier to hedge an interest rate rising environment via paying swaps than shorting bonds, many players chose the former and bond/swap spreads widened in May, before correcting back in slightly early June.

Key Issues - The Bank of Thailand kept policy steady in May. However, the comments were slightly hawkish, citing that inflation risk has increased markedly and should inflation continue to accelerate, the Monetary Policy Committee would stand ready to adjust the monetary policy stance accordingly.

We maintain our house view for the Bank of Thailand to cut its 1 day repo rate by 25 basis points in the fourth quarter this year and the first quarter next year to 2.75 per cent (from 3.25 per cent currently) and view hikes as unlikely since they would undermine the government's fiscal stimulus efforts.

GDP printed a firm 6 per cent year-on-year in the first quarter of this year. However, we note that inventories contributed a lofty 2.6 percentage points to growth, which is clearly unsustainable and hence we expect economic growth to slow down ahead. Separately, the medium term bond supply outlook should become an increasing concern, as the budget deficit for fiscal year 2009 (October 2008 to September 2009) is expected to rise to around Bt249 billion (or 2.5 per cent of GDP) from Bt165 billion in the current fiscal year (or 1.8 per cent of GDP).

Outlook - Inflation worries and a hawkish central bank should pressure front end bond yields higher through the third quarter, before easing back down in fourth quarter on rate cut expectations.

Long end bonds (10Y) should stay bearish in the coming quarters, as we anticipate bond supply for the next fiscal year to be hefty and back loaded. Thus, we expect the government bond yield curve to bearish flatten in the penultimate quarter of this year, before pivotally steepening in the final quarter of this year.

We also expect the IRS curve to flatten, as front end paying interest seems prevalent, while asset swap flows should moderate the pace of IRS rate rises at the long end.