(Reuters) - India's government bond yield curve has flattened after an unexpected hawkish turn to monetary policy amid tight domestic liquidity, dampening appetite for short-term securities, and the trend is likely to continue in the near term, analysts said.
The spread between the one-year and 10-year bond yield has dropped to its lowest in over four years, with short-end yields rising rapidly on the back of expectations that the rate hiking cycle could continue in coming months.
"The government bond yield curve will continue to bear flatten when you see such inflation data," said Akhil Mittal, fixed income fund manager at Tata Mutual Fund.
"In the current scenario, the shorter end is expected to react more sharply, and this trend may continue for some more time."
The Reserve Bank of India's monetary policy committee raised its key lending rate by 25 basis points last week and left the door open for more increases citing high inflationary pressures, defying expectations for a long pause after this hike.
The RBI was vindicated after data earlier this week showed India's annual retail inflation in January rose to 6.52%, breaking above the central bank's 2%-6% target band for the first time since October.
On Wednesday, the RBI sold 364-day treasury bills at a yield of 7.16%, and the spread with the 10-year benchmark bond yield is now at a level last seen in September 2018.
The 364-day T-Bill yield has risen by 26 basis points in the last three weeks, while the benchmark bond yield is largely unchanged after some intermittent volatile moves.
Banking system liquidity moved into a deficit of around 270 billion rupees over the last week, forcing the RBI to skip its 14-day variable rate reverse repo and instead opt for 14-day repo infusion.
Madan Sabnavis, chief economist at Bank of Baroda, expects the banking system liquidity deficit to rise to 1 trillion rupees ($12.10 billion) going ahead, and that along with rate hike fears has led to the sharp rise in T-Bill yields.
"Liquidity conditions have tightened and as we move closer towards March-end, things will continue to worsen, so pain at the shorter end is expected to increase further," said Rajeev Pawar, head of treasury at Ujjivan Small Finance Bank.
Meanwhile, the liquid five-year 7.38% 2027 bond yield was at 7.29%, while the benchmark 7.26% 2032 bond yield was at 7.34%. The new 10-year 7.26% 2033 security, which will soon replace the existing benchmark note, was yielding 7.32%.
"The spread between the five-year and 10-year bond yields will shrink further," Tata Mutual Fund's Mittal added.
The five-year bond yield is trending upwards since the RBI's rate hike followed by the unexpected jump in inflation.
"There is an increased uncertainty now over the terminal repo rate, especially as the (U.S.) Federal Reserve is set to hike rates further," said Abhishek Upadhyay, senior economist at ICICI Securities Primary Dealership.