Mumbai: The yield on the 10-year benchmark government bond fell to a four-and-a-half year low of 5.499% on Thursday as inflation fell to 6.84% in the week ended 6 December from 8% the previous week, raising hopes of deep rate cuts by the Reserve Bank of India (RBI).

Pressure on RBI: The Reserve Bank of India building in New Delhi. Ramesh Pathania / Mint

The government securities of all maturities rallied and the trading volume ballooned to at least Rs25,000 crore against daily average volume of Rs10,000-15,000 crore.

According to bond dealers, the sudden drop in inflation will give RBI more room for deep rate cuts and even a reduction in the cash reserve ratio (CRR), or the portion of deposits that banks are required to maintain with the central bank in cash. RBI has cut CRR by 350 basis points and its policy rates substantially since October. One basis point is one-hundredth of a percentage point.

Traders are now driving down the bond yields on expectation of at least a 50 basis points cut on policy rates. Some are betting on a 100 basis point CRR cut.

“I am expecting a rate cut in the first week of January," said N.S. Venkatesh, managing director and chief executive officer of IDBI Gilts Ltd, a firm that trades bonds. Venkatesh expects the 10-year bond yield to drop to 5%. He expects at least 75 basis points cut in repo rate, or the rate at which RBI infuses liquidity, and 100 basis points cut in reverse repo, or the rate at which the central bank sucks out liquidity from the system.

“The thrust of the government has moved from inflation targeting to growth targeting. I expect pressure on RBI to reduce interest rates," said Pradeep Madhav, managing director, STCI Primary Dealer Ltd.

Madhav expects 100 basis points cut in CRR and 50 basis points cut in both the repo and reverse repo rates.

The sharp drop in yields across all maturities has made the sovereign yield curve flat with the yield on short-term three-month treasury bill, one year treasury bill as well as the 10-year bond hovering around the same level.

However, every dealer is not bullish on the interest rate outlook. “There is no logic on the yields to fall this much," said the chief dealer of a public sector bank, requesting anonymity. “When inflation is at 6% and repo at 6.5%, yields going down below 5.5% is ridiculous."