Shorter-dated Indian government bonds are likely to lag longer-dated ones again as tighter cash conditions and monetary policy reduce demand for debt that is most sensitive to interest rates.
Analysts at IDFC First Bank and Deutsche Bank expect the Reserve Bank of India could raise rates by as much as 75 basis points in the coming months. That would come on top of a 25-basis-point increase on Oct. 7. A basis point is one-hundredth of a percentage point.
The central bank is also pulling cash out of the banking system. Surplus cash has dropped sharply from a record high reached in early September.
Bond market signals
The bond market has already started to show the strain. The gap between short-term and long-term yields narrowed earlier this month to its smallest level since May, then widened again as crude oil prices fell.
Yields on treasury bills, which mature within a year, have also climbed to around their highest level in more than a year.
The spread between five-year and 10-year yields has narrowed to about 32 basis points from 37 basis points at the end of August, according to data compiled by Bloomberg. IDFC First Bank and Quantum Asset Management Co. are among those expecting the curve to flatten further.
Sneha Pandey, a fixed-income fund manager at Quantum, said the curve could briefly flatten to zero or even invert if the RBI drains liquidity more aggressively and markets start pricing in a higher final rate.
VRC Reddy, head of treasury at Karur Vysya Bank, said short-dated paper is more exposed to near-term rate expectations and liquidity conditions. He expects it to keep trailing as inflation trends point to further rate increases.
How the cash was drained
Short-end yields rose more steeply after the RBI began withdrawing cash that had flooded the banking system. Lenders had swapped dollars raised through a diaspora deposit programme for rupees.
The central bank has since removed liquidity through sell-buy currency swaps and bond sales worth 1.25 trillion rupees ($13.3 billion) under open market operations. As a result, the banking system’s cash surplus has shrunk to 2.3 trillion rupees as of Nov. 5, down from 11 trillion rupees in early September.
The government also cancelled a sale of 182-day treasury bills last week, as traders were likely to demand higher yields.
Effects on borrowing and growth
Higher short-term yields can push up funding costs for banks and companies, tighten credit and eventually weigh on consumption, investment and economic growth. So far, growth has held up despite the Middle East war.
An Axis Bank research note said cash conditions are expected to stay tight. It warned that the drain could hit deposits, and a gap between deposit growth and credit growth may open up again.
Some relief, but uncertainty remains
Last week, the five-year yield fell 33 basis points, more than the 22-basis-point drop in the 10-year yield. Crude prices slumped, easing inflation pressure on the oil-importing country and reducing bets on a jumbo half-percentage-point rate hike in December.
The outlook is still unclear. A Bloomberg survey of economists suggests retail inflation, due Thursday, will likely reach the RBI’s 6% upper tolerance level for the first time in two years. That would make a rate hike likely at the next policy meeting.
Suyash Choudhary, chief investment officer at Bandhan AMC Ltd, said Indian bonds face intensifying domestic inflation for the foreseeable future, along with higher global neutral rates as countries compete for capital. He expects the yield curve to stay relatively flat, with the floor for yields likely to have moved up.