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Short-term gilts suggest RBI policy normalisation still some time away

NEW DELHI: Perhaps the biggest takeaway for markets from the Reserve Bank of India’s monetary policy statement last week was that normalisation of the ultra-accommodative policies has started in the country.

The central bank, aware of the risks of adding fresh liquidity to the banking system amid upside risks to inflation, paused the government security acquisition program that it had adopted since April and announced a larger quantum of funds to be withdrawn from the system through its variable rate reverse repo operations.

However, one of the key market metrics which indicate a bearish view on interest rates has barely registered any change – short-term gilt yields.

Papers maturing in up to five year or so are typically the most sensitive to liquidity conditions and the interest rate scenario.

And if one goes by the price action in such securities, the market is pretty confident that any normalisation is some time away.

Yields on the most liquid 3-year and 5-year securities have actually declined 3 basis point and 7 basis points respectively since RBI’s monetary policy statement in August. Hardly a sign of a market which is expecting imminent normalization of monetary policy.

While yields on Treasury Bills had shot up in the runup to the policy statement, that was more to do with the commentary surrounding a possible central bank response to a sudden surge in crude oil prices.

In the days preceding the policy statement, many segments of the market, including major foreign lender Citibank, had predicted a rise in the reverse repo rate, from its current all-time low of 3.35 per cent.

RBI’s decision to set the cutoff rate at a recent reverse repo auction at 3.99 per cent — just below the benchmark policy repo rate of 4.00 per cent — also stoked speculation that the central bank was looking to realign money market rates to the repo rate rather that the reverse repo rate of 3.35 per cent.

The reverse repo rate effectively represents the overnight cost of funds for banks due to the huge surplus of liquidity – currently estimated around Rs 7 lakh crores — in the banking system.

What actually happened on the ground was different. RBI’s Monetary Policy Committee held all key rates steady and while it did start the tricky process of modulating excess liquidity from the banking system, the consensus is that the central bank has pulled off the task quite adroitly.

“The main reason why short-term bonds have not reacted to the policy is because the RBI has done a very good job with communication,” PNB Gilts Managing Director and Chief Executive Officer Vikas Goel said.

“Look at MIBOR (Mumbai Interbank Offer Rate). The fixings are not anywhere close to the repo rate and it will take some time to head even to the 3.70 per cent or 3.80 per cent levels. Basically the market is now of the view that whatever happens will happen gradually. There will not be a crash landing. I expect that in either December or February there could be a 15-basis-point rise in the reverse repo rate but the actual cost of funds is unlikely to shoot up anytime soon,” he said.

Yields on longer-tenure bonds may have climbed on Friday but that phenomenon was inevitable, given demand-supply dynamics. Absorbing Rs 12.05 lakh crore, a large portion of which is longer-term papers, is no easy task, especially when RBI steps back from upfront committed bond purchases.

Typically, markets take a day or two to digest monetary policy statements, but the proof of the pudding is always in the price action. Going by that metric, the lack of response in short-term bond yields is testament to the market’s confidence that policy accommodation is not going to leave abruptly, despite high oil prices and the US Federal Reserve’s guidance of tighter monetary policy.

RBI would undoubtedly be relieved after the reaction in short-term bonds as most corporate borrowing is benchmarked against government securities maturing in 3 to 8 years.

Growth indicators may be showing a revival in the economy but it is still far from being capable of absorbing the shock of a sudden rise in borrowing costs.

“Now that the policy is done, I think short-term bonds will remain around these levels,” a senior trader at a large foreign bank said on condition of anonymity.

“5.63 per cent, 2026 had sold off earlier and then traders had a renewed interest in the bond because there was no extra GST borrowing. The trade is again getting crowded, but I think looking for carry is a sensible option in the current scenario where liquidity is still plentiful and rate hikes are some time away,” he said.

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