RBI’s Liquidity Stance: Did Bond Markets Get It Wrong?
A tug of war between the RBI and bond markets returned on Friday as the central bank announced a reversal of the CRR cut.
Bond yields rose. And then they fell. All in the space of a couple of hours. In the middle, a scheduled bond auction fell through as traders tried to force the central bank to sell securities at a higher yield. The central bank rejected the bids, sending a signal that while it’s moving toward “normalising” liquidity operation, it will keep a tight rein on bond yields to ensure financial conditions don’t tighten.
On Feb. 5, the RBI said it would reverse the 100-basis-point cash reserve ratio in two tranches back to 4% by May 22, 2021. In announcing the reversal, Reserve Bank of India Governor Shaktikanta Das said “the CRR normalisation opens up space for a variety of market operations to inject additional liquidity”.
The signal the central bank may have been trying to send was that it would take a more active liquidity management stance from here on and support the additional government bond supply with open market operation purchases, said a person in the know. This should have been seen as positive by the bond market, which would be better supported by outright central bank bond purchases compared to excess liquidity sloshing around in the banking system.
The added assurance that the RBI “will ensure the orderly completion of the market borrowing programme in a non-disruptive manner”, should have dispelled any lingering concerns, the person cited earlier said on the condition of anonymity.
But that’s not how it played out. The 10-year yield spiked to over 6.14%.
Bond Traders Saw It Differently
At the scheduled bond auction on Friday afternoon, bids traders placed were at least 10-15 basis points higher than the prevailing rates in the case of the 5-year and 10-year bonds up for auction, said a bond market participant on the condition of anonymity. Since auction of these securities was cancelled, no data for weighted average yields bid was available. In the case of the 40-year bond, however, the RBI devolved the auction on primary dealers. The weighted average yield bid on this security was 6.69%, auction data shows.
According to the bond market participant cited earlier, the market’s confidence had already been shaken by the volatility in yields on budget day, when the government announced a higher-than-expected fiscal deficit. Since no open market operation was announced alongside the cash reserve ratio reversal, nervousness rose and willingness to stomach any further losses was at a low.
While the central bank will likely announce OMO bond purchases sometime next week, bond markets may take time to settle. The fact that the 40-year bond was devolved may add to nervousness as there are limited buyers for this security in the secondary market. As such, markets will wait to see if the RBI will buy this bond as part of its open market operations, the bond market participant quoted above said.
RBI Will Soothe Nerves
The friction between bond markets and the RBI isn’t uncommon. After a tug of war last year, the markets and the central bank settled into a comfort zone for the 10-year bond yields at near 6%.
“We look forward to the continuance of the common understanding and cooperative approach between market players and the RBI during 2021-22 also,” Das said in a statement, once again signaling that the central bank intends to keep bond markets in good cheer.
As such, the central bank may soothe nerves over the next couple of weeks with either more regular bond purchases or a larger quantum of them. In doing so, the RBI will signal that it is taking a more “activist stance” towards liquidity management, the first person cited earlier said. This should assure bond markets.
The central bank will also likely ensure that liquidity conditions remain as comfortable as in 2020-21, through the combination of demand brought in by the higher held-to-maturity limit for banks and the open market operations, this person said.
The RBI needs to mute (not break) the linkage between the recalibration in the overnight rate and its exaggerated transmission to higher up the curve, Suyash Choudhary, head of fixed income at IDFC Mutual Fund, wrote in a note on Friday. “...We fully expect unwind/absorption measures ahead around liquidity (CRR unwinds, term reverse repos, MSS (Market Stabilisation Scheme) issuances at some point) to coexist with twist and outright OMOs (Open Market Operations) to ensure that the effect higher up the curve is blunted,” Choudhary said.
The bond markets will be watching for the quantum of purchases but also the level of yields at which the central bank chooses to come in. A new line in the sand for the benchmark yield will need to be set by the central bank through the timing of its bond purchases for traders to breathe easy, the bond market participant cited earlier said.