RBI continued with its recent habit of springing positive surprises on the market by announcing an almost completely unexpected INR 1.25 lakh crores Open Market Operations (OMO) program for May. It will be recalled that in a similar unexpected move the central bank had upscaled April’s OMO calendar by INR 40,000 crores. With RBI dividend to government around the corner, there was virtually no expectation of further OMOs in May. Including these new announced OMOs, RBI would have conducted more than INR 5 lakh crores of OMOs over the first 5 months of this calendar year. We hypothesize below on possible reasons for this very pro-active intervention by the central bank.
We start off by setting the context. From an overall macro perspective 3 things are reasonably clear:
- Global uncertainties have risen manifold and will pose some cyclical headwinds to India’s growth as well.
- The government has demonstrated strong fiscal credibility for some years now and is rightly pursuing a conservative stance. The medium term benefits from this approach will likely far outweigh short term boosts from cyclical fiscal expansion, in our view. That said, some mild expansion, for example from nominal growth slowdown, is well understood and appreciated.
- Thus, the maximum room for cyclical response rests with monetary policy. With inflation projected to be at target, and risks of currency weakness led imported inflation not likely to be significant, RBI has flexibility to respond and has been doing so proactively. We have recently brought down our terminal repo rate expectation to 5.50% and risks of even lower terminal exist should the global growth slowdown turns out to be harsher than currently envisaged. An equally important component is the proactive liquidity management that RBI has embarked upon, which is necessary to ensure broad based transmission of rate cuts.
Having established this, we turn to possible reasons for the stepped up liquidity creation from RBI.
- RBI has a substantial forward short dollar book (almost USD 79 billion as at end February 2025) with a significant chunk of this maturing within 3 months. It is possible that the central bank is in the process of extinguishing some part of this and is neutralizing the consequent impact on rupee liquidity with OMO operations. We will know whether this is the case more clearly over the next couple of months when more updated dollar forward book data is available.
- The central bank could be targeting a much larger sustained liquidity surplus (2-3% NDTL vs 1-2% that we had earlier thought) in order to ensure that there are no constraints whatsoever to broad based transmission of rate cuts.
- RBI could be implicitly capping sovereign yields, again to facilitate better transmission. However, we must say that this is the least likely reason in our view, even though this will very likely be the effect of OMO operations.
Market and Investor Implications
Given the underlying need for monetary policy to act decisively (which it is), and given the wide range of possible reasons for the very proactive response RBI is taking to liquidity infusion, market participants may be happily speculative for now. This should keep bond market volatility contained (absent very sharp global moves) and the direction of travel fairly clear. With a terminal repo rate of 5.50% (or lower), a conservative fiscal stance, well-behaved inflation (absent weather-related new food price pressures), and proactive monetary policy, bond valuation is still attractive in our view. This last point about valuations requires a bit more elaboration. There seems to be a view in the market that 10 year government bond yield may struggle to go below 6.25% on a sustained basis and that at those levels it is effectively pricing in the rate cut cycle. This view seems largely basis recent history where indeed there are just 2 occasions of 10 year below 6.25% (2016 and 2020-21).
We disagree and note the differences below:
- 2020-21 was marked by a large fiscal expansion in view of the pandemic. Center’s fiscal deficit doubled from 4.6% of GDP in FY20 to 9.2% in FY21. This led to a substantial steepening of the yield curve amidst relatively low appetite for longer maturities. Unlike then, the current phase is marked with strong fiscal consolidation and a credible roadmap for the same going forward. Thus, even as the yield curve will naturally steepen at lower levels, the extent of steepening is unlikely to be that large. Put another way, there may still be adequate appetite for duration for the foreseeable future.
- India is now not only a top 5 economy but also very well regarded for its macro-stability. Furthermore, given a very low starting point of FPI exposure to Indian sovereign bonds, the next few years will likely continue to see strong offshore demand for our bonds. If the US dollar is indeed exiting a multi-year cycle of ‘exceptional’ preference, and is now poised to generally weaken for some time, then large global institutional investors will have an added incentive to step up India allocations, even as this process is unlikely to play out linearly. Thus, flow dynamics are also likely quite different than in the past.
All told then we remain quite comfortable with owning duration via government bonds, where we think the medium term demand-supply equation remains the best. The non-SLR curve has lost its inversion in line with our view and now allows for reaching up to mid-duration segments (up-to 5 years maturity or so). We also like the SDL curve for intermediate duration segments (up-to 6-7 years maturity). From an investor point of view, reinvestment risk continues to remain the number one risk which needs hedging via appropriate duration selection. Needless to add, this has to be basis risk appetite for intermittent volatility and adequacy of time horizon for investments.
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