RBI Rate Hike Expectations, Tight Liquidity Put Pressure On Short-Term Bond Yields

New Delhi, Nov 9 (KNN) Short-term Indian government bond yields are expected to face upward pressure amid tightening banking liquidity and expectations of further interest rate hikes by the Reserve Bank of India (RBI), potentially widening the gap with longer-term securities.

RBI Rate Hike Expectations Put Pressure On Short-Term Bonds

IDFC First Bank and Deutsche Bank expect the RBI to raise interest rates by up to 75 basis points in the coming months, following a 25-basis-point hike on October 7.

The central bank has also stepped up liquidity withdrawal, reducing the banking system's cash surplus to Rs 2.3 lakh crore as of November 5 from Rs 11 lakh crore in early September, reported the Business Standard.

VRC Reddy, head of treasury, Karur Vysya Bank, said shorter-duration bonds were more sensitive to interest rate expectations and liquidity conditions, making them vulnerable to further underperformance if inflation prompted additional monetary tightening.

Yield Curve Flattens As Banking Liquidity Tightens

The yield spread between five-year and 10-year government bonds has narrowed to around 32 basis points from 37 basis points at the end of August, indicating a flattening of the yield curve.

Rising short-term yields could increase borrowing costs for banks and companies, tighten credit conditions and potentially affect consumption and investment. The government also cancelled a planned sale of 182-day Treasury bills last week amid market conditions.

According to an Axis Bank research note, tighter liquidity could put pressure on bank deposits and widen the gap between deposit growth and credit expansion.

The RBI has withdrawn surplus liquidity through sell-buy foreign exchange swaps and Rs 1.25 lakh crore worth of bond sales under open market operations. 

These measures followed a liquidity surplus generated partly through banks' conversion of foreign currency raised under a diaspora deposit programme.

Markets Track Inflation And Further Liquidity Withdrawal

Sneha Pandey, fixed-income fund manager, Quantum Asset Management, said the yield curve could temporarily flatten to zero or move into mild inversion if the RBI accelerated liquidity withdrawal and markets priced in higher peak interest rates.

However, falling crude oil prices provided some relief to bond markets last week. The five-year bond yield declined 33 basis points, compared with a 22-basis-point fall in the 10-year yield, reducing expectations of a steep rate hike in December.

Market participants are also tracking retail inflation data due later this week. A Bloomberg survey of economists indicated that inflation could reach the RBI's upper tolerance limit of 6 per cent for the first time in two years.

Suyash Choudhary, chief investment officer, Bandhan AMC, said domestic inflation pressures and higher global interest rate expectations could keep India's bond yield curve relatively flat, with yields likely to remain at higher levels.

(KNN Bureau)