The events of the past fortnight, however, have left bond traders a bit confused about the signals emanating from Mint Street.
On the one hand, the central bank’s recent liquidity actions seem to suggest its intention to raise overnight money market rates, while on the other hand, its decisions in the main public debt auction of the past week indicate its reluctance towards returns on gilts heading north.
As an upsurge in cases of the Omicron strain has weighed on domestic growth prospects, the central bank faces a certain dilemma. The sovereign bond yield curve is not behaving quite the way the RBI wants it to be and the central bank is now struggling to regain control.
RBI SIGNALS, THE PERFORMANCE CURVE REACTS
Over the past two weeks, the government bond yield curve has seen what traders call “bear flattening,” a phenomenon in which yields on short-term securities rise at a faster rate. than those of their longer-term counterparts.
The yield on the 5.63% 2026 paper, which is the most liquid 5-year bond, climbed 17 basis points this month, while that of the benchmark 10-year bond at 6, 10% 2031 increased by 14 basis points over the same period. The rise in yields on shorter-term government securities was even more pronounced, contributing to the “flattening” of the yield curve.
Given that a large portion of corporate borrowing is valued against yields on sovereign bonds in the 3-5 year maturity bracket, this development does not bode well for the fundraising outlook, although the liquidity in the banking system remains abundant.
The sharp rise in short-term bond yields was primarily driven by recent RBI liquidity actions, bond traders said.
After unequivocally signaling its intention to continue with measures to support growth during its monetary policy review earlier this month, the RBI unveiled a measure that Treasury officials say had the effect of do exactly what the central bank did not officially announce at the policy meeting – a hike in the reverse repo rate.
The central bank on December 20 unexpectedly announced a 3-day floating rate reverse repo auction valued at Rs 2 lakh crores; to be held on the same day. Unlike the fixed rate reverse repo window, which offers a rate of 3.35% (the current reverse repo rate), banks can receive up to 3.99% of the RBI as part of the a variable rate reverse repurchase agreement.
By offering banks the ability to park excess funds close to the 4.00% repo rate, the RBI has essentially moved short-term money market rates closer to the benchmark policy rate without formally tightening monetary policy, traders said.
The market conclusions were clear – despite threats to growth; the RBI wants to guide the price of liquidity upwards as inflationary impulses remain firm.
What came like a thunderclap for bond traders was the central bank’s decision to shift a significant portion of last week’s gilt auction to the books of primary traders.
In doing so, the RBI made it clear that it was uncomfortable with the high level of returns demanded by market participants during the primary sale.
As some traders have asked, where exactly does the RBI want the yield curve to be valued? On Tuesday, the 10-year bond yield closed at a 22-month high of 6.50% and according to market sources, this is a level the central bank does not want to exceed .
“It was expected that after decentralization there would be an OMO or OT (Operation Twist) so that they would take decentralization out of the market,” said PNB Gilts Managing Director and CEO Vikas Goel.
“When the announcement wasn’t made, it was sold… the RBI, I think, will get uncomfortable at around 6.50%. Basically I think we’re getting closer to fair value. Maybe 6.50 percent would be the high end of the range, ”he said.
It is perhaps understandable that the RBI has so far been reluctant to announce new rounds of open market operations, given the enormous amount of liquidity flowing through the banking system.
The RBI has repeatedly called the sovereign yield curve a public good, as it serves as a pricing benchmark for borrowing costs in the broader economy.
It appears the central bank is keen to steer what are usually independent market forces in a particular direction, but traders are unsure of where the balance will be struck between boosting growth and containing inflation. Recent price action says it all.