Bond yields likely to stay in a range till September post RBI cues, say experts

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Yields on government bonds are likely to trade in a range for the next three months after the Reserve Bank of India (RBI) indicated a pause on aggressive liquidity withdrawal measures in its policy decision on June 8, money market experts said.

“The bond market is relieved that liquidity withdrawal will happen in a calibrated, gradual manner,” said Ritesh Bhusari, Deputy General Manager – Treasury at South Indian Bank.

“Even if we assume that a cash reserve ratio (CRR) hike is due in August (although not a base case), it could at best suck out liquidity to the tune of around Rs 70,000 crore, and the surplus would still be more than Rs 2-2.5 lakh crore,” Bhusari said. “The bond market should be okay with this level of liquidity and a large sell-off can be averted.”

Relief rally in bond market

The RBI today kept the CRR, the portion of deposits that banks must hold in liquid cash, unchanged at 4.50 percent. Some economists and bond market participants had expected the ratio to be hiked today. The CRR was hiked unexpectedly by 50 basis points (bps) at the Monetary Policy Committee’s (MPC) off-cycle meeting in May with the aim to withdraw Rs 87,000 crore from the banking system.

Since bonds are fungible, the reduction in the quantity of liquidity has a greater impact on yields than a rate hike. A CRR hike today would have sucked out more liquidity, driving up yields sharply even when a 50-bps rate hike was largely priced in by the bond market.

The benchmark 10-year yield closed at 7.49 percent today, 3 bps below yesterday’s closing level. The shorter five-year bond yields dropped 10 bps, while the three-year bond yields lost eight bps and two-year yields erased seven bps. Bond prices and yields move in opposite directions.

The RBI is currently looking to withdraw pandemic-era accommodation to keep a lid on soaring price pressures in the economy. It has stopped its own Quantitative Easing-style Government Securities Acquisition Programme (G-SAP) since October last year and is indulging in reverse repo auctions to suck out excess liquidity from the banking system.

Due to the RBI’s liquidity absorption measures, the banking system liquidity is now down to Rs 3.2 lakh crore, from Rs 8.1 lakh crore in March and Rs 9.96 lakh crore in September.

RBI Governor Shaktikanta Das, announcing the monetary policy today, said that while normalising the pandemic-related extraordinary liquidity accommodation over a “multi-year time frame,” the central bank “will ensure availability of adequate liquidity to meet the production requirements of the economy”.

This signals that the RBI may be comfortable with the current level of liquidity surplus in the system at this stage and may not rush to aggressively withdraw it, experts said.

“The status quo on CRR was a breather for the bond market. But most importantly, there is no hint that liquidity withdrawal will be accelerated any time soon, and the bond market should take comfort from that,” said Debendra Kumar Dash, Senior Vice President – Treasury at AU Small Finance Bank.

“The RBI has communicated well that there will be adequate liquidity in the system. So, the market seems to be secure on that front,” Dash said. He does not expect the RBI to hike the CRR in the August policy and expects the 10-year yield to stay in a 7.50 percent to 7.75 percent range till September.

Calibrated approach

Experts said that the RBI could opt for other tools in its liquidity management kitty rather than going for a CRR hike and spook the bond market.

“This can be achieved by forex intervention by the central bank via outright dollar sales in spot or via sell/buy swaps,” said Vivek Kumar, Economist at QuantEco Research. “Both options would depend on market variables, while its impact on liquidity would be piecemeal, in contrast to a move on CRR, which will have an immediate impact.”

While the sale of government securities by the RBI is another alternative for draining liquidity, excess reliance on the same would exacerbate the duration pressure in the bond market, added Kumar.

The RBI has so far sold Rs 6,125 crore of the bonds in the secondary market over April and May, according to central bank data.

HDFC Bank’s chief economist Abheek Barua also had a similar view.

“We do not expect surplus liquidity to move to zero or deficit mode this year,” Barua said. “The central bank has repeatedly emphasised that it would provide enough liquidity in the system ― balancing any change due to its forex operations, government spending or seasonality ― in a manner that the normalisation is non-disruptive for growth.”

Temporary relief?

However, experts said that today’s move could be a temporary relief for the bond market and that yields could harden in the long term as the RBI’s rate hike cycle continues and inflation pressure continues to mount.

“The 10-year yield is expected to hover in the 7.50 percent to 7.75 percent range till September. Thereafter, we do see an imminent increase towards 8 percent by December as supply pressures mount and as inflation will continue to stay elevated,” said Venkatakrishnan Srinivasan, Founder and Managing Partner, Rockfort Fincap, a Mumbai-based debt advisory firm.

The RBI, too, has limited options at its disposal right now to tame soaring bond yields. The RBI is walking a tightrope on debt market management as it drains surplus liquidity from the system in an effort to tame inflation.

Inflation, according to the RBI, is expected to stay above the central bank’s upper tolerance level for three quarters of this financial year and average at 6.7 percent for FY23. Hence, the RBI’s rate hike trajectory is expected to continue in the upcoming policies.

Barclays expects the RBI to deliver a 35 bps rate hike in August, and then raise the policy rate by 25 bps to 5.50 percent in October from 4.90 percent, while also switching to a neutral stance.

Add to that, the supply pressure in the debt market is huge. The central government will borrow a massive Rs 14.31 lakh crore from the domestic bond market this year, of which Rs 8.5 lakh crore would be borrowed in the first half of FY23.

“With faster and higher degree of monetary policy normalisation appearing to be playing out as a base case globally as well as in India, we now revise upwards the expectation of 10-year yield to 8 percent before the end of FY23, from 7.75 percent earlier,” added QuantEco’s Kumar.