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Higher-than-expected cutoff at RBI reverse repo, US developments bring hawks swooping back to mkts

Higher-than-expected cutoff at RBI reverse repo, US developments bring hawks swooping back to mkts

29 Sep 2021

NEW DELHI; Indian financial markets have been whipsawed quite a bit over the past couple of days as a flurry of central bank developments, both global and domestic, have created speculation among investors about how soon the flood of international liquidity unleashed during the Covid crisis will get mopped up.

Benchmark equity indices shed more than 1 per cent on Tuesday, the rupee closed at a one-month low, while yield on the 10-year benchmark government bond climbed 2 basis points. Bond prices and yields move inversely.


On the domestic front, the most recent trigger was what seemed to be an innocuous cutoff rate set by the Reserve Bank of India at a variable rate reverse repo auction.

Even though the aim of such operations –being undertaken by RBI since January 2021– was ostensibly to align the cost of funds to the benchmark rates, Tuesday’s cutoff rate set by the central bank was the first one in recent times to be set close the repo rate of 4.00 per cent, and not the actual operative rate, which is the reverse repo rate of 3.35 per cent.

On Tuesday, RBI set at a cutoff of 3.99 per cent at a seven-day variable rate reverse repo auction, the highest possible cutoff at such an operation and just shy of the prevailing repo rate.

For investors, both in bond and equity markets, RBI’s move has set the cat among the pigeons when it comes to guessing when the central bank will choose to undertake a proper realignment of interest rates towards the benchmark policy rate – something that has not been done for the past couple of years.

Over the past couple of years, it has been the reverse repo rate which has served as the operative funding reference for markets as the central bank has released a gush of liquidity to keep funding costs low amid a pressing need to revive economic growth but before and during the coronavirus crisis.

If RBI is indeed sending out a message that it wishes to send the cost of funds back to the benchmark policy rate, one of the principal ways in which it would achieve this would be to start meaningfully reining in the massive surplus of liquidity in the banking system.

For the last six months at least, the core liquidity –sum of the government’s cash balance and the liquidity in the banking system-has been around Rs 10 lakh crores.

RBI has already taken the step of draining out a larger quantum of liquidity by increasing theoi quantum of variable rate reverse repo operations and there is speculation that in coming months the tenures of such operations will also see an increase.

Further, earlier this month in its ‘Government Securities Acquisition Programme’, RBI for the first time under these operations, also announced a sale of government securities along with purchases, albeit those of shorter tenures.

All these signals point towards the central bank’s intent to now push the pedal as far as normalizing liquidity management operations are concerned.

Speculation is now rife that in the upcoming monetary policy statement on September 8th, the RBI could perhaps detail a timeline for a hike in the reverse repo rate, maybe for December.

To be fair, when it comes to acting on the reverse repo rate, the RBI can make a move outside of scheduled policy statement as the Monetary Policy Committee’s mandate is to act on the repo rate and not the lower bound of the Liquidity Adjustment Facility corridor.


For equities, which have hovered near lifetime highs for some months now, a tightening of the liquidity spigot, both global and domestic, could result in a reversal of some of the extraordinary flows that have been propelled to the Indian market.

As long as cost of funds, internationally, has remained near record lows, the market has been confident that even as growth prospects remain fragile, flows are assured.

Now with US Treasury yields climbing close to 20 basis points over the last month on account of the Federal Reserve hinting at a reduction in quantitative easing in November and a likely tightening of monetary policy soon after, assets in emerging markets such as India are losing sheen as evidenced by the reaction in domestic markets.

“In equities, the reaction has been a bit more sudden as the market had initially shrugged off the Fed’s statement, but now with the confusion regarding the US debt ceiling and a possible default threatening to push up US yields even more the matter is hitting home,” a trading head at a foreign bank said on condition of anonymity.

Republican senators in the US have been opposing efforts by Democrats to raise the country’s debt ceiling, sparking fears of the world’s largest economy defaulting on debt obligations.

“It is a double whammy because signs of improved growth prospects and monetary tightening in the world’s largest economy have also pushed up crude oil prices and the rupee is now starting to also suffer, the RBI will have to act on liquidity to a certain extent if the Fed starts tightening” he said.


There are some who believe that the recent reaction in markets may have been a knee-jerk one and that when it comes to the RBI, the process of lifting interest rates is still some time away.

According to many treasury officials, the high cutoff set at the variable rate reverse repo auction was more an outcome of some banks refraining from parking at the window before the end of the July-September quarter.

The fact that the reverse repo auction was not fully subscribed on Tuesday supports this point of view. Typically, state-owned banks, which are the largest holders of deposits in the system, prefer to hold onto cash towards the end of the quarter in order to prepare for any unseen outflows.

“We could see a cutoff of 3.60 per cent again in the next reverse repo auction, I think the 3.99 per cent cutoff was a one-off.”

Another factor that has given some the market some solace is a recent flurry of interactions by RBI officials in which they ⁶have stressed on the fact that the central bank will give a very clear heads-up to markets before embarking on the process of normalization.

It was evident from the RBI’s previous monetary policy statement in August that going ahead, he direction for interest rates is northward, but the underwhelming growth numbers for Apr-Jun seemed to have pushed that eventuality further away.