The Reserve Bank of India will conduct a simultaneous sale and purchase of bonds, it said on Thursday, in a move seen by market participants as an attempt to bring longer-term yields lower.
It is the first time the RBI has conducted a special open market operation (OMO) of this kind, similar to the 'Operation Twist' carried out in the United States near the start of the decade.
Bond yields have been rising since the RBI unexpectedly left its key repo rate unchanged earlier this month, even as it slashed its forecast for economic growth to its lowest in over a decade.
The RBI said it will buy 100 billion rupees' ($1.4 billion) worth of the current benchmark 10-year bond while selling four bonds maturing in 2020 for an equivalent amount.
"The action of Operation Twist by the RBI today is encouraging," said Madhavi Arora, economist at Edelweiss Securities.
"We have been arguing that RBI should work towards reducing the term premium for real economy gains. The current steep yield curve barely reflects the true state of the economy," she added.
The central bank said it hade decided to conduct the special OMO after reviewing the liquidity and market situation and assessing financial conditions.
Most market participants expect the government to announce measures to tackle the growth slowdown in the federal budget in February while there are serious concerns of fiscal slippage this year, too.
The government may thus be forced to borrow more from the market to fund its fiscal deficit which could push bond yields up more.
The benchmark 10-year yield had risen as much as 37 basis points to 6.84% from its level before the RBI shocked markets by keeping rates steady this month. It is currently still up 28 bps.
The yield curve has steepened sharply despite the RBI having cut the key repo rate by 135 bps since February.
"The RBI possibly knows something that the market doesn't. Everyone knows there is going to be a fiscal slippage and possibly they feel its going to be large enough and they need to manage bond yields," a senior debt trader at a private bank said.
"The 10-year bond yield could fall by 7-8 bps at open and by around 15 bps eventually," he added.
Simultaneously buying long-end bonds and selling short-end bonds should lead to a flattening of the yield curve.
But traders said it was not clear whether there would be a series of such auctions or just the one. They are hoping the RBI will step in to prevent sharp rises in yields at a time when there is a clear need to encourage growth.
In the July-September quarter, India's economic growth slid to a six-year low of 4.5%.