Traders in the Indian bond market are concerned about the central bank's efforts to withdraw excess money from the financial system. These concerns are heightened by rising inflation and global selling of debt assets, which could trigger a prolonged fall in bond prices.
Some major government debt underwriters, such as ICICI Securities Primary Dealership Ltd. and IDFC First Bank Ltd., predict that the yield on benchmark 10-year bonds could exceed the 2026 peak reached in May, rising to 7.25% by December 31, marking the highest level in three years. Furthermore, Citigroup Inc. has moved its forecast for the Reserve Bank of India's interest rate hike from December to October.
This shift in sentiment is sharp. Just a month ago, the central bank attracted a record $127 billion from the Indian diaspora through special deposits, aiming to strengthen foreign exchange reserves and protect the rupee. These inflows, which surpassed even RBI's own estimates, brought the surplus cash in the banking system to an unprecedented 11 trillion rupees ($115 billion), helping stabilize domestic bonds against rising yields in major markets to multi-year highs.
However, due to the liquidity surplus and the renewed surge in oil prices, which increases inflationary risks, the RBI began to act. Its plan to withdraw 1 trillion rupees from creditors through open market bond sales caused a sharp rise in yields across the curve; the 10-year rate reached 7.08% on Tuesday. Markets are bracing for similar measures to be implemented in the coming weeks and months.
Ashish Vaidya, Head of Treasury at DBS Bank Ltd. in Mumbai, noted: 'The prospects are complicated, and it is difficult to name a yield peak.' He added that the situation has clearly changed, and traders are now readjusting to a more complex scenario regarding supply and higher inflation.
The RBI's move came after excess funds led to interbank lending rates falling significantly below its established benchmark level. Easing financial conditions proved contradictory to recent policy signals calling for rate hikes to curb inflation.
The timing is particularly unfavorable for bond traders, as the central bank is acting as a seller precisely when government borrowing begins in the second half of the fiscal year, exacerbating the already high burden on the debt market.
Michael Van, Senior Currency Analyst at MUFG Bank Ltd., wrote in his note: 'The situation where too much of a good thing can become problematic may very well apply to the situation India is currently facing.' He emphasized that the RBI's most urgent task is to use its full arsenal of tools to absorb this excess liquidity.
According to QuantEco Research, the central bank will need to quickly withdraw another 2 trillion rupees from the banking system, which could be achieved through short-term currency swaps or the issuance of securities under the Market Stabilization Scheme and Treasury Bills.
Chandresh Jain, Rates and FX Strategist for EM Asia at BNP Paribas SA, expects bonds with maturities from three to ten years to come under further selling pressure. He observed that local banks held bonds with maturities of three to five years due to excess funds, and as this surplus diminishes, the yield on these papers could rise faster than the yield on 10-year bonds.
Data released on Monday showed an acceleration of inflation in India in August, bringing it closer to the upper limit of the RBI's target range of 2–6%, potentially narrowing the scope for maintaining the current exchange rate. Market observers are increasingly expecting the central bank to raise the benchmark rate by 25 basis points in its October policy decision, adding further pressure on yield increases.
Kaushik Das, Chief Economist for India at Deutsche Bank AG, believes that 'the next natural step will be a 25 basis point increase in the repo rate in the October policy, followed by another 25 basis point hike in December.'
When markets reacted to the RBI's announcement of open market bond sales, the sell-off in short-term debt was more pronounced. On Tuesday, the yield on five-year notes jumped by 21 basis points, the largest jump since May 2022, outpacing the 10-year yield increase by 6 basis points. On the same day, comparable US Treasury bonds reached their highest level since 2007.
Foreign investors reduced their positions in indexed Indian bonds by 2,470 crore rupees on Tuesday, following an outflow of 4,730 crore rupees on Friday, the largest since April last year. Indian markets were closed on Monday.
Navinen Ramnani, Chief Treasury and Investment Dealer at UCO Bank, stated: 'The bond market bears direct consequences of the RBI's aggressive pivot towards OMO direct sales.' He concluded that managing the cash surplus is critical, as persistent inflationary risks mean that overnight free rates are a luxury the central bank cannot afford.