Tighter monetary conditions in India are likely to weigh on shorter dated government bonds relative to longer maturities, as expectations for further rate increases and reduced banking system liquidity curb demand for the notes most sensitive to policy moves, Bloomberg reported on Monday.
IDFC First Bank and Deutsche Bank expect the Reserve Bank of India to raise rates by up to 75 basis points in the coming months, after the 25 basis point increase on October 7 that took the repo rate to 5.50 percent. The tightening extends to liquidity management: the central bank is withdrawing cash from the banking system after excess funds reached a record high in early September. The yield gap between short and long government bonds narrowed to its lowest since May earlier this month, then widened again as crude oil prices fell. V. R. C. Reddy, treasury head at Karur Vysya Bank, told Bloomberg that short term bonds are more sensitive to immediate rate expectations and liquidity conditions, and that further hikes remain possible given current inflation trends.
Monday’s liquidity operation showed the new pricing in practice. The Reserve Bank’s four day variable rate repo auction, notified at 50,000 crore rupees, drew 62,872 crore rupees of bids and allotted 50,003 crore rupees at a cut off rate of 5.51 percent and a weighted average rate of 5.54 percent, with only 15.18 percent of bids at the cut off allotted. Banks are now paying the policy rate, and a fraction above it on average, for four day central bank money, rather than lending surplus cash below it as they did when the system was flush in September.
The combination is the classic setup for front end underperformance: policy expectations pull short yields up directly, while a shrinking cash surplus removes the structural buyer that had kept money market rates pinned below the repo rate. Longer maturities, driven more by term premium and external moves such as crude, have been steadier by comparison. India’s October consumer price print, due November 12, and the Monetary Policy Committee decision on December 4 are the next tests of how much of the expected 75 basis points is delivered.