The Reserve Bank of India (RBI) on Saturday unexpectedly ordered banks to deposit their extra cash with it, in a bid to absorb excess liquidity generated by a government ban on larger banknotes.
Many Indians deposited their old notes with their banks after the ban on 500 and 1,000 rupee notes ($7.30-$14.60) on Nov. 8, which is aimed at tax evaders and counterfeiting.
Banks had put some of this cash into government bonds, sparking a rally that saw the benchmark 10-year bond yield fall more than 50 basis points to its lowest in more than 7-1/2 years.
The central bank said banks would need to transfer 100 percent of their cash under the RBI's cash reserve ratio from deposits generated between Sept. 16 and Nov. 11, saying it was a temporary measure that would be reviewed on or before Dec. 9.
Traders called it a drastic move intended to dent the rally in bond markets, adding that the RBI could have opted for more modest measures such as sucking out some of the liquidity through sales of market stabilisation bonds or telling banks to park funds under reverse repos.
The action could also temper market expectations that the central bank would cut interest rates by 25 basis points at its next policy review scheduled for Dec. 7, after already easing them by the same amount at its last review in October.
"The move is more of a ham-handed one than the finesse expected from the RBI," said Shaktie Shukla, founder of boutique investment advisory firm Kaithora Capital.
"The liquidity sweep will definitely halt the down move in (bond) yields," he added. "It will also temper the euphoria pre- RBI policy."
The move is likely to drain over 3.24 trillion rupees ($47.29 billion) from the banks, according to Reuters estimates.
Traders said bond market yields could rise 8-10 bps on Monday, given that the RBI move would deprive the key source of funding seen in the past two weeks, while banking shares would likely take a hit.
Bond investors had also bet India's demonetisation action would dent economic growth as consumers held back on purchases, raising the prospect of a rate cut by the RBI.
At the same time the bond rally had increased hopes it would lower borrowing costs in the economy and allow banks to reduce some of their lending rates.
On Friday the central bank also relaxed its liquidity auction rules by expanding its basket of securities that it accepts as collateral.