The increase in bond yields on Monday is little more than a knee-jerk reaction owing to disappointed expectations of a rate cut. For the past two months, the yield on the 10-year government security has been in the range of 8.05% and 8.26%. The markets seem to have digested the worse and the consensus is tilted towards lower rates in the coming months.

To be sure, the 25 basis points cut in the cash reserve ratio (CRR) eases liquidity and may put on hold open market bond purchases in the near term. One basis point is 0.01%. CRR is the percentage of deposits banks have to keep with the Reserve Bank of India (RBI) and now stands at 4.5%.

However, advance tax collections, the usual spike in credit growth in the second half of the year and RBI’s sales of dollars in the foreign-exchange forwards market will add to liquidity pressures.

Thus, the CRR cut is no more than what is needed to ensure liquidity remains comfortable and open market operations (OMO) should resume in the medium term. A 28 August Reuters poll of dealers puts OMO buying at 90,000 crore for this fiscal year; RBI has bought bonds worth 54,600 crore so far.

In any case, RBI’s tone in this statement is a lot more dovish. Even though the central bank remains focused on price stability, the fact that CRR has been eased and it made some noises about growth means the door is open for future cuts in repurchase rates.

Secondly, with the US Fed and European Central Bank turning open their liquidity taps, investors are searching for higher yields elsewhere. This has made emerging market bond funds hot, points out fund tracker EPFR in a 14 August report. From a local perspective, the risks of a sovereign downgrade come down because of the recent reform measures and diesel price hike. Thus, foreign institutional investor inflows into bonds are likely to go up, say dealers. At the end of 31 August, they still had an unutilized quota of $4.5 billion (out of the $20 billion cap according to RBI rules) left to buy government bonds.

Thirdly, demand for government bonds from local institutions is likely to shoot up. Low credit growth and fear of increasing stressed assets means that banks invest—more than what is required by regulation—in government bonds. All these point to softer bond yields in the coming months. There’s a big rider, though, which is that inflation shouldn’t play party pooper.

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