10-year yields rise: Why was the market tracking the VRRR auction closely?

A bond expert estimates that a 10bps rise in the 10-year GSec yield approximately results in Rs 1 loss in the price of bonds held by the banks.

Market participants were watching the participation of banks in the Variable Reverse Repo Rate (VRRR) auction keenly on October 6, expecting it to decide any further rise in government bond yields.

VRRR is one of the tools the central bank uses to drain liquidity from the markets.

The 14-day VRRR auction held by the Reserve Bank of India (RBI) on October 6 for Rs 50,000 crore received offers only for Rs 6,668 crore.

Also read: 14-day VRRR gets muted response; banks parked only Rs 6,668 crore: RBI data

“The auction saw weak participation from the banks, after various VRRR auctions of 28 days, 14 days, and 3 days  failed,” said Venkatakrishnan Srinivasan, founder and managing partner of Rockfort Fincap, and a bond-market veteran.

Seeing this tepid reaction, the central bank had no option but to resort to another method to reduce the liquidity in the banking system -- open market operations (OMO) sales. But OMO sales mean higher supply of bonds in the market, which means higher yields.

Therefore, the announcement of the OMO sales by the central bank led to the new 10-year benchmark yields closing at 7.3412 percent, the highest since March 23, according to a Reuters report. The market expects OMO sales of Rs 50,000 crore between this October and next March, according to Srinivasan.

RBI vs banks: a standoff

Srinivasan said that the RBI Governor Shaktikanta Das’ address indicated the concern about how the banks were managing their liquidity requirements -- “that banks have preferred to place funds under the overnight SDF (standing deposit facility) instead of offering them in the main 14-day variable rate reverse repo (VRRR) operations. Elevated levels of MSF (marginal standing facility) borrowings amidst substantial funds parked under the standing deposit facility (SDF) is symptomatic of skewed liquidity distribution in the banking system”.

In the address, Governor Das said, “It is imperative that banks assess their actual liquidity requirements over the reserve maintenance cycle and bid accordingly in the auctions under main 14-day VRRR operations.”

Also read: Are the markets heading for a perfect storm? 

What are RBI’s options?

According to him, the central bank may conduct the OMO sales in the auction mode and there is a possibility that people may bid higher, as much as 7.4 percent.

“If the RBI rejects it, then the yields will improve. If it accepts it, then the entire market will further ask for higher levels till the time the RBI rejects bids. With this, the yields may tend to go up further and banks’ treasury profits will be affected,” he said.

Srinivasan estimates that a 10bps rise in the 10-year GSec yield approximately results in Rs 1 loss in the price of bonds held by the banks.

That’s how the banks stand to lose from this stand-off.

But the central bank may not be so quick to accept higher rates because it may also affect the yields of the Government of India’s scheduled borrowing programme and hence “the RBI may not be too comfortable” with rising yields.

But there is another option the central bank has, of letting yields rise in illiquid securities. The central bank could structure the OMO sales with a mix of liquid and illiquid securities of various tenors.