The 10-year paper lost its pre-policy gains after the Reserve Bank of India (RBI) kept the interest rates unchanged, dashing hopes of the bond traders who were expecting the central bank to react to the government’s recent fiscal reform measures.

At its mid-quarter policy review, the RBI kept policy rates unchanged, but slashed the Cash Reserve Ratio by 25 bps to 4.50 per cent. CRR is the portion of deposits that banks have to keep with the RBI. The cut will infuse Rs 17,000 crores into the banking system and will take effect from September 22.

Expecting a repo rate cut, the yield on a 10-year bond was hovering at 8.11 percent before the policy announcement and moved higher by 7 basis points to settle at last week closing of 8.18 per cent.

The move was triggered by position cutting by traders, who went long on bonds ahead of the policy, anticipating a repo rate cut as well as the market taking the CRR cut as a negative for bonds, said a research note by Barclays. The bonds rallied by almost 9 basis points before the policy, said the traders.

The CRR cut reduces the near-term probability of RBI bond purchases, but the long term situation is expected to get better through the government spending, said Krishnamurthy Harihar, treasurer at FirstRand Bank.

Yields have eased by over 20 basis points since January and by 30 basis points in the current financial year, mainly due to improved liquidity and the RBI's bond purchases through open market operations (OMO).

``Though the liquidity is comfortable as of now, there will be a shortfall in liquidity in the near future for anywhere between Rs 75,000 to 1,00,000 crore. However, through the government spending, the situation is expected to improve by October,’’ said Harihar.

The bankers are hopeful that the RBI will likely be proactive in providing liquidity support to the market. Adds the Barclays report, “we continue to recommend investors to stay long bonds in India and maintain our overweight stance’’. The government will announce the borrowing for the second half of the financial calendar later this month.

The central bank’s target of money supply growth is 15 per cent and currently it is 13.7 per cent, while the projected credit growth is 17 per cent, but at present it is 16.4 per cent.

The targets would be difficult to achieve without support from the apex bank, said the bankers. “The liquidity situation is comfortable, however, if the credit off-take picks up during the festive season, the RBI might resort to further OMOs,” said SV Venkatasubramanian, General Manager, Treasury, Andhra Bank.

Though the diesel price hike might create an upside in the inflation, the yields would be range bound between 8.05 to 8.25 per cent, he added. "For the next one month, the 10-year yield is likely to move in 8.10-8.30 percent," said A Prasanna, Economist, ICICI Securities.

The RBI had in the past said that open market operations will be conducted if the liquidity situation worsens. The mid-quarter policy, however, did not mention OMOs. However, the timing and quantum of further easing will remain “conditioned by careful and continuous monitoring of the evolving growth-inflation dynamic”, according to the Barclays note.

(Edited by Prem Udayabhanu)

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