India's bond curve is poised to flatten further as the Reserve Bank of India steps up liquidity withdrawals, prompting some investors to favor 10-year debt over five-year notes.
The five- to 10-year yield gap is expected to narrow as the RBI drains surplus cash, pressuring shorter maturities, according to Industrial and Commercial Bank of China Ltd. and Anand Rathi Global Finance Ltd. The five-year yield may rise to around 7% from a current 6.94% if the central bank remains aggressive in its policy tightening, according to ICICI Securities Primary Dealership Ltd.
Excess banking-system liquidity is prompting the RBI to withdraw funds, putting upward pressure on shorter-dated yields as it seeks to contain prices. The central bank has already withdrawn more than 1 trillion rupees ($10.4 billion), and the pace of further cash absorption, alongside any additional rate hikes, will determine how far the yield curve flattens.
“The short end should see further flattening as the RBI steers overnight rates near or above the repo rate to ensure effective transmission,” said Alok Sharma, head of treasury at ICBC in Mumbai. He sees the five-year and 10-year gap narrowing to as much as 10 basis points and the curve turning flat or mildly inverted if overnight rates move meaningfully above the repo rate.
Gap Between Short-, Long-Term Bonds Shrinks on Cash Drain
The RBI's liquidity stance is key, with the overnight rate, the rate banks charge each other for one day, still below the repo rate, the central bank's policy rate. Surplus cash has kept overnight borrowing costs below the policy rate, prompting the RBI to drain liquidity through market operations.
Some investors are now positioning for a flatter curve. Harsimran Sahni, head of treasury at Anand Rathi, recommends selling the five-year benchmark and buying the 10-year bond, a trade that would benefit from a narrowing yield gap.
The next test comes Wednesday, when the RBI is expected to raise its policy rate by 25 basis points to 5.50%, according to a majority of economists surveyed by Bloomberg. It would be the first increase since February 2023, with any signal of a more aggressive tightening path likely to add pressure on the short end of the curve.
“There is still some scope for bear flattening if the RBI indicates that there are more hikes likely,” said Abhishek Upadhyay, an economist at ICICI.
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