Bond yields likely to rise 20 bps

Centre’s extra borrowing will ease pressure on RBI’S liquidity operations as banks will absorb excess G-secs

Bond yields are expected to jump 15-20 basis points when the market opens on Monday, in case the Reserve Bank of India (RBI) does not announce any open market operations (OMOS) to help manage the huge spike in borrowing programme by the government.

On Friday, after the markets closed, the government said it would be borrowing ~12 trillion for the full fiscal year, instead of originally planned ~7.88 trillion, owing to Covid-19. Incidentally, earlier on the same day, the 10 -year bond yields had fallen below 6 per cent for the first time since February 2009. The government had also introduced a new 10 -year paper with a cut-off of 5.79 per cent.

The ~12-trillion borrow was “above anything that the market expected,” according to Harihar Krishnamurthy, head of treasury of Firstrand Bank. This will, in likelihood, push the yields on the new 10 years paper to just about 6 per cent or more.

But the banking system’s liquidity surplus will also get curtailed due to the heavy borrowing. The government plans to borrow ~30,000 crore every week, against less than ~20,000 crore originally planned. Risk-averse banks can deploy their ~8-trillionplus surplus liquidity in buying these bonds. But short-term rates, too, will get pushed up and the yield curve will steepen, said Krishnamurthy, adding that rate cuts will have to come even as the last inflation reading was nearly 6 per cent.

While the indicator of slippage in the fiscal deficit was not unexpected, Axis Bank Chief Economist Saugata Bhattacharya expressed surprise at the magnitude of the proposed use of market borrowings to finance the fiscal gap.

“Given the potential access to alternative sources like T-bills, National Small Savings, etc, these additional borrowings suggests that official thinking the magnitude of the FY21 fiscal gap at this time might be even larger than the ~7-8 trillion we have been working with and projected,” Bhattacharya wrote in a report.

The bond yields will rise by at least 10 to 15 basis points on the borrowing news without any clarity on open market operations (OMO) by the Reserve Bank, said Devendra Dash, head of asset-liability management at AU SFB. But there would also be buying interest due to the ample free liquidity in the banking system. Eventually, the RBI will have to conduct something like an

Operation Twist, where it buys longterm bonds and sells an equivalent amount of short-term bonds.

“The RBI is accumulating huge treasury-bills which can be used for such Operation Twists. Hopefully, the extra borrowing may be absorbed by the RBI through OMOS, but the timing is crucial,” Dash said. He expects the RBI to announce OMO of ~2-3 trillion.

Rate cuts can still happen, “but long bonds won't benefit,” said Badrish Kulhalli, head of fixed income at HDFC Life. “Only OMO will help. Markets will look for the RBI support for almost all of the additional borrowing,” Kulhalli said.

The RBI has other options like capping how much banks can park in the reverse repo, and forcing them to buy bonds instead. Besides, options such as standing deposit facility (SDF) is there in which the RBI receives the surplus liquidity without any collateral at a lower rate than reverse repo to fight excess liquidity. But that may not be needed ultimately as the banks will now use up their liquidity to buy government bonds.

And there are also state government bonds, vying for the same surplus liquidity. Between the Centre and states, the total borrowing could easily rise to ~20 trillion, and that crowd out private corporate borrowers.

But the huge surplus liquidity is not the new normal. It has a shelf life, and will go away in a few months. The incremental liquidity creation will likely get adjusted with a reduction in ways and means advances and by normalisation of cash reserve ratio in the second half, according to Soumyajit Niyogi, associate director at India Ratings.

“Conducting OMO purchase when liquidity surplus is above ~5 trillion, could create a signal extraction problem and central bank’s credibility. It’s better to buy directly in the secondary or primary market for the avoidance of unwarranted announcement effects,” Niyogi said.