Easy money has driven bond yields down sharply across the curve in 2016-17, primarily after the government purged 86% of the cash in the economy through demonetization. The bond market, which had its best run last year, is now staring at a tough year ahead and has lost almost all of the potential parachutes.
The rather accommodative monetary policy stance has now been changed to neutral by the Reserve Bank of India (RBI), which means rate cuts are a distant dream. But bond traders lost their last hope on 6 April after the central bank hiked its reverse repo rate by 25 basis points and said it would begin to mop up the excess liquidity through all available instruments. Yields jumped nearly 20 basis points, the biggest single-day rise in two months and bonds are unlikely to recover in the near term. The 10-year bond yield has risen by 35 basis points since January. A basis point is one-hundredth of a percentage point.
To be sure, sterilizing a mammoth Rs4 trillion is no easy task and deputy governor Viral Acharya indicated that liquidity will be copious for most of 2017-18. But the central bank is well cognizant of the threat to inflation from persistent surplus liquidity. Given that the monetary policy committee has flagged several upside risks to inflation, RBI would not want the additional pressure on prices from easy money.
The central bank said it would use cash management bills to drain short-term frictional liquidity surplus created by build-up of government balances. Issuances of Market Stabilisation Scheme bonds will also be actively pursued. All this entails additional supply of bonds over and above a large government borrowing and a huge supply of state government bonds. Traders expect another 25 basis points rise in bond yields over the next three months.
As the public withdraws more cash, and individuals and companies begin borrowing from banks, RBI expects the surplus to shrink. While optically loan growth would look encouraging in the second half of fiscal year 2018, it is unlikely that incremental disbursals would be enough to deploy a lion’s share of the surplus liquidity.
And herein RBI will use open market operations (OMO) to sell bonds. Bond sales from the central bank’s stock would not only result in additional supply but also provide a nudge to yields by RBI’s bids.
A lot will depend on how fast the liquidity finds its way into corporate loans and currency before the central bank chooses its last resort to impound surplus liquidity. For now, the bond market will begin to turn jittery over the prospects of OMO bond sales.