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Informist, Friday, Jun. 6, 2025

 

By Aaryan Khanna

 

MUMBAI – The Reserve Bank of India's surprise on rates and liquidity are seen detrimental to government bonds, an astonishing sentiment after a larger than expected 50-basis-point rate cut. However, traders see little reason to buy gilts with the central bank openly saying there is not much more for it to do to boost growth, implying there is little chance of further rate cuts.

 

The Monetary Policy Committee's decision Friday initially brought cheer to the market as it delivered an outsize rate cut, which was on the radar but only just. Rate-sensitive yields of bonds maturing up to five years fell immediately, and they will remain well bid with the monetary authority not only cutting the policy repo rate but also the cash reserve ratio by 100 bps.

 

Instead, it was the panel's decision to change its stance to 'neutral' from 'accommodative' that stung the majority of the bond market – an even more unexpected development than the one on rates, and also a negative one. With the softer policy stance reversing after only a single meeting, hopes the terminal policy rate would be 5.25% or 5.00% petered out, and traders now see the policy repo rate at the current 5.50% for an extended period.

 

"The RBI has front-loaded rate cuts, and we do not anticipate further cuts in the next 3-6 months. Returning to a neutral stance was unexpected and possibly premature in our view," Axis Mutual Fund wrote in a note after the policy. The fund sees the 10-year benchmark gilt in a 6.00-6.40?nd, a slightly wider range than the market consensus of 6.10-6.35%.

 

RBI Governor Sanjay Malhotra only reinforced the view that the bar for further rate cuts was very high. First, he said the MPC was left with very limited space to support growth after frontloading rate cuts. Speaking at the post-policy press conference, Malhotra delivered another whammy, saying that monetary policy had done its job on the growth front and now it was important for other drivers of the economy to kick in.

 

With this, traders said the 10-year 6.33%, 2035 bond hitting a 6.11% yield – the four-year low the benchmark had hit earlier in the day after the rate cut announcement – will be a tall task. Incentivising traders will be even more difficult as trading desks burnt their fingers Friday with the volatility in the market, due to the whiplash from the announcements of the repo rate cut, stance change, and cash reserve ratio cut, in that order. Traders have called the bond "rally" closed after the torrid pace at which they have made money since March, with the 10-year gilt yield down nearly 50 bps at its lows Friday.

 

"On its own, the yield is not moving to 6% now. The issue is with the stance: the RBI shut the door to further easing within two months," said Vijay Sharma, senior executive vice-president at PNB Gilts Ltd. "If there are no OMOs, or a crash-type event in the global economy, both of which look unlikely, we have seen the best of gilt yields."

 

LIGHT THROUGH THE CRACK

Bond yields had been sliding due to the anticipation over further monetary policy easing as well as favourable demand-supply conditions. The RBI's government bond purchases in 2025, at over INR 5.20 trillion, dwarf the market's own. Expectations of further such buys had dwindled heading into the MPC, and the RBI's cash reserve ratio cut of 25 bps each starting September all but ensures that it will stay out of adding liquidity in the near-term, dealers said.

 

Regardless, the MPC could still cut rates by another 25 bps later in 2025-26 (Apr-Mar) if GDP growth trends suggest it would miss the year's forecast of 6.5%, dealers said. Moreover, the current real interest rate – the repo rate net of expected inflation – is at 1.8%. This is near the top of the range given by the RBI last year for a "neutral" policy rate that maximises growth while keeping inflation in check.

 

"The market's read of no further rate cuts seems a bit hasty. While a policy rate cut in August now seems off the table, evolving growth-inflation data could still open room for a future 25 bps reduction," said Nitin Agarwal, head of trading at ANZ Bank India.

 

Traders also conjectured Malhotra's strong statement on rates was keeping in mind the shrinking interest rate differential between US and India government bonds. The RBI did not want to make Indian bonds more unfavourable for foreign investors to hold after the rate cut, and the rate guidance was probably seen necessary to assuage these concerns, dealers said. The spread of the 10-year US Treasury yield over the 10-year benchmark gilt yield is at two-decade lows, which has led to consistent gilt sales by foreign portfolio investors. Should the US Federal Reserve also cut interest rates later in 2025 and the spread widen, the MPC could take the opportunity to cut rates in December or February, dealers said.

 

In the near-term, banks flush with liquidity and having to park money at the Standing Deposit Facility at 5.25%, look to invest in gilts until there is demand for credit. Some of this credit growth would have to be generated in line with the RBI's push, and this is likely to dampen incremental demand for bonds sooner rather than later, dealers said. With the RBI seen pausing its open market operations, demand from institutional investors and banks between one weekly gilt auction and the next will be closely gauged for the direction of gilt yields maturing in 10 years or more.

 

"We will be forced to lend, because there are no ways to park that cash except in the market," a senior treasury official at a state-owned bank said. "I think this phase of the rally is over, but the (10-year) yield will not go beyond 6.30?cause the lower funding rate will make it quite attractive to buy at that point of time. And the RBI can always come and deliver some more good news on liquidity."

 

A TALE OF TWO SEGMENTS?

The bulk of the disappointment is applicable to the 10-year benchmark and bonds of longer tenures. Demand for short-term bonds and Treasury bills has been immense as traders saw minimal risk in this segment, and the sentiment has redoubled after the rate cut Friday. After these announcements, Nomura increased its conviction on going long on the five-year benchmark 6.75%, 2029 gilt with a target of 5.50% yield from the current 5.82%. It expects the terminal rate will be 5.00%, a view that is much more optimistic than what the market expects.

 

Moreover, the RBI has already announced a cash reserve ratio cut that will add over INR 2.5 trillion over nearly four months starting September. That cushion should help give banks more confidence in pushing credit during the festival season. At the same time, it will allow the RBI room to deliver its dollar buy spot-sell forward positions which are likely to drain rupee liquidity, dealers said.

 

"With Friday's decision, short- to medium-term bonds are expected to perform well, supported by a substantial liquidity surplus following a 100 bps cut in the cash reserve ratio," Siddharth Chaudhary, head of fixed income, Bajaj Finserv Asset Management Co., said. "However, as market expectations approach the terminal rate, profit-booking is evident in longer-term bonds."

 

Others see it as more of a safe bet amid broader market turmoil rather than a moneymaking opportunity. The spread of the 10-year benchmark over the five-year gilt yield may widen by another 5-10 bps from the 42 bps Friday, but further outperformance seems unlikely as levels seem lucrative to take profit.

 

Since the RBI has placed its cards on the table, the bond market will begin to discount Friday's announcements sooner rather than later, dealers said. Malhotra's mere mention of variable rate reverse repo operations also spooked some traders, even as the governor said overnight rates should remain at the lower end of the policy corridor of 5.25% if the tool was not deployed.

 

"Given the fast-evolving policy landscape and the governor's proactive demeanour, we expect preference for short-term bonds as the upside risks to longer-term bond yields will also be magnified, whenever the cycle turns," Agarwal of ANZ Bank said.

 

With the return of the 'neutral' policy stance, traders fear quick policy steps that could flip the easing cycle on its head. With aggressive rate actions when inflation is seen only 30 bps below the 4% medium-term target in FY26, an inflation surprise on the upside could prompt a "trigger-happy" governor and MPC to start hardening rates in the overnight market.  End

 

Edited by Ashish Shirke

 

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