RBI’s ₹1 lakh crore cash drain: Why short-term bonds are taking the biggest hit

Indian short-term bonds came under sharp selling pressure after the Reserve Bank of India (RBI) announced plans to drain ₹1 lakh crore of surplus cash from the banking system through government bond sales. Five-year bond yields jumped as much as 22 basis points (bps) to 6.80%, the steepest rise since May 2022, while the benchmark 10-year yield rose as much as 9 bps before closing 6 bps higher at 7.07%, Bloomberg News reported.

Why the short end is bearing the brunt

The RBI said it would conduct the bond sales in three tranches starting September 17. The move is aimed at absorbing excess liquidity that has built up in the banking system following large inflows through recent RBI measures to attract foreign capital.

The impact has been more severe on shorter-maturity securities because much of the additional supply from the RBI sales is concentrated in bonds maturing in three to six years.

“The decision is the most stringent action the RBI has taken so far and the logical casualty has been the five-year segment, which was richly valued,” VRC Reddy, head of treasury at Karur Vysya Bank, told Bloomberg News. He expects the yield curve to flatten further as short-end yields rise.

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Bond market faces more supply pressure

The RBI’s move comes at a difficult time for the government bond market, which is already dealing with record government borrowing. Nearly ₹8 lakh crore of federal borrowing is lined up over the next six months, while state governments are also typically heavy borrowers during this period.

The central bank, however, has a sizeable stock of government securities available for sale. Its holdings rose more than 40% in the last fiscal year to around ₹23 lakh crore, equivalent to about 18% of outstanding central government securities, according to Citigroup, as cited by Bloomberg News.

For bond investors, the additional RBI supply could keep yields under pressure, particularly in the three-to-six-year segment.

Inflation and crude add to the pressure

The liquidity drain also comes as the inflation outlook has become less comfortable. India’s inflation rose in August, moving closer to the upper end of the RBI’s 2%-6% target range.

At the same time, higher crude oil prices are adding to inflation risks and putting pressure on the country’s external finances. Bloomberg News reported that global bond markets were also under pressure, with US yields above 5% and crude prices continuing to rise.

The combination has increased expectations of tighter monetary policy. Citi analysts have brought forward their expectations for an RBI rate hike to October, while Kotak Mahindra Bank economist Upasna Bhardwaj expects borrowing costs could rise by 50-75 bps.

Rupee weakness adds another complication

The rupee also weakened, closing 0.4% lower at 95.96 per dollar, its weakest level since late July. Traders cited by Bloomberg News said the RBI intervened through dollar sales to support the currency amid rising oil prices.

With liquidity being drained, bond supply rising and inflation and crude prices creating fresh risks, the short end of India’s yield curve is likely to remain particularly sensitive to RBI actions and rate expectations.

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