India's Short-Term Bonds Set To Trail As RBI Tightens Cash

What happened to liquidity and short-term bonds

The central bank has been pulling money out of the banking system, taking the surplus down to about 2.3 trillion rupees on Nov. 5 from roughly 11 trillion rupees in early September. Tools included sell buy foreign exchange swaps and open market bond sales totaling 1.25 trillion rupees, or 13.3 billion dollars.

Short-end yields climbed after the RBI started soaking up cash that had flooded in when banks converted dollars from a diaspora deposit program into rupees. That pressure has pushed bills maturing within a year to levels near their highest in more than a year. Earlier this month, the gap between short and long maturities compressed to the tightest since May, then eased back as crude prices dropped.

Why traders expect more rate pressure

IDFC First Bank Ltd. and Deutsche Bank AG see scope for as much as 75 basis points of additional tightening in the months ahead, following the 25-basis-point hike on Oct. 7. That backdrop tends to hit the front end first because it reacts more quickly to policy expectations and cash conditions.

Sneha Pandey, fixed income fund manager at Quantum, added that if liquidity is withdrawn more forcefully and markets price a higher peak policy rate, "a temporary flattening to zero, or even a mild inversion, cannot be ruled out." IDFC First Bank and Quantum Asset Management Co. both expect further curve flattening.

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How the moves affect yields, inflation and credit

Bloomberg data show the five versus 10 year spread is around 32 basis points, down from 37 basis points at the end of August. Last week, the five year yield slid 33 basis points while the 10 year fell 22, helped by a drop in crude that eased inflation worries for an oil importer like India, trimming the odds of a half percentage point hike in December.

Axis Bank expects cash conditions to stay modest, and says the liquidity drain is likely to weigh on deposits, potentially reopening a gap with credit growth. When short-term yields rise, borrowing becomes more expensive for banks and corporates, credit conditions tend to tighten, and, over time, consumption and investment can come under strain. Reflecting the higher rate demands, the government canceled the sale of 182 day treasury bills last week after traders were apparently seeking richer yields. Economic activity has remained resilient even with the Middle East war.

What this means for your portfolio

According to a Bloomberg survey, India's retail inflation reading due Thursday is expected to touch the RBI's 6 percent ceiling, a level not seen in two years, pointing to a likely rate increase at the next policy meeting. In plain English: a flatter curve, tighter cash, and more hikes on the table tilt performance risks toward short duration, rate sensitive notes while deposit and credit trends bear watching as the RBI stays restrictive.

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