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Yields likely to firm up on any RBI hint of liquidity normalisation

Yields likely to firm up on any RBI hint of liquidity normalisation

15 Aug 2021

Mumbai: Bond yields are likely to inch up this week as investors factor in a normalisation of liquidity tone together with persistently high inflation, even as early signs of a possible change in Reserve Bank of India’s monetary policy take shape. The central bank will release the minutes of its Monetary Policy Committee (MPC) meeting on Friday, which will likely give more reasons to the bond market to push yields higher.

Earlier this month, the RBI left rates unchanged, ignoring potential inflationary pressures and despite raising its own forecast for inflation, as it stayed the course on supporting a nascent economic recovery after the pandemic.

However, the first signs of debate on monetary policy tapering also emerged in the lone dissenting voice that voted at the MPC against a protracted run for the current ultra-easy liquidity stance.

Economists say these are early signs of a change in the monetary policy stance which will likely start with the RBI tightening banking system liquidity.

The market is already priced for normalisation of the liquidity adjustment facility (LAF) over October-December, “and the RBI could further minimise risks of abrupt tightening in financial conditions by providing a conditional guidance to prepare markets in the October review,” economists at ICICI Securities Primary Dealership (I Sec PD) wrote in a note.

I Sec PD expects the central bank to start increasing the policy interest rate next fiscal year, after first normalising the excess liquidity through the reverse repo.

In fact, it has already started absorbing excess liquidity. While keeping rates unchanged, the RBI has expanded the scope of the variable reverse repo rate auction till the end of September to ₹4 lakh crore.

Banking system liquidity is estimated to be ₹8-10 lakh crore and some banks may prefer to keep their idle money at the 3.35% reverse repo rate. This week, lower liquidity and higher inflation forecasts are likely to force traders to reconsider their positions. They will look to sell if minutes from the RBI’s policy meeting show that more members were reconsidering their stance to keep rates unchanged.

A Bloomberg poll of 15 traders, fund managers and economists showed they expect the benchmark 10-year yield to climb to 6.40% by December, from Friday’s close of 6.24%.

Nomura economists expect inflation to remain elevated, averaging around 5.6% between July and September, moderating to about 5% in the December quarter due to base effects, before rising above 6% in the first quarter of calendar 2022.

“Core inflation is likely to remain sticky and trend close to 6% throughout. In our view, the August policy meeting already bore initial signs of a policy pivot via calibrated liquidity normalisation. We believe this will be followed by the phasing out of durable injectors of liquidity, a 40-basis-point reverse repo rate hike in the December quarter and 75 basis points of repo/reverse repo rate hikes in calendar 2022,” Nomura said.